Saturday, December 19, 2009

The Impact of Governance on the Economy - Part 2, The Firm Level

In our previous post (The Impact of Governance on the Economy - Part 1, The Macro Level) we came to the conclusion that 'good' governance increases the economic prospects of a country (all other things being equal) through a complicated interplay of return- and risk variables that are positively influenced by improved governance. However, in a globalizing economy governance improvement is not an easy recipe to increased valuation and economic growth at the macro level. It has to be part of a smart, thorough economic, political and legal package of reforms. It is definitely not a panacea for growth.

An important mechanism through which improved governance can translate into higher valuation is the positive impact that good governance will have on value-increasing international fund flows like Foreign Direct Investments (FDI) and (Equity) Portfolio Investments by foreign entrepreneurs and institutional and private investors. The positive effect of international bank debt is not so big, since this type of international fund flow tends to reverse quickly and often at the wrong moment for the recipient nation. International investors feel better protected in countries with better governance regulations. 

However, investors do invest in projects or individual firms. The next question that we need to address is therefore: What about differences in Corporate Governance between firms within a specific country?

In this contribution we will try to answer this question. It is an important one when studying Emerging Markets. First, as we saw in the previous contribution governance levels in these countries are often lower than in developed nations. Does that mean that individual firms should do more themselves, or does it imply that a lack of good governance at the country level translates into a situation in which corporations can do less themselves? To answer these questions our analysts found a lot of useful information for investors in a 2002 World Bank paper by Leora Klapper and Inessa Love entitled 'Corporate Governance, Investor Protection and Performance in Emerging Markets'.

Why Investing in Individual Emerging Markets firms?
The world is changing. We are moving from a 2-block structure to a 3-block one. The 'old' world was one in which North America and (Western)Europe-Japan-Oceania were the dominating blocks. In terms of GDP (real, macroeconomic level) and stock market valuation these 2 blocks dominated the other countries of the world when looking to the latter as a group. Obviously that negligible third group is the one containing the Emerging Markets. During the last ten years the economic success stories in Emerging winners like China, Brazil, India, Russia and a few others have totally changed the world. Partly helped by globalization - which enabled these nations to maintain their growth path via international trade supported by international investment flows through FDI and portfolio investments - the GDP weight of the 'third block' grew to about 30 percent. However, the weight in terms of market valuation of their stock market didn't reach further than about 15 percent and has even dropped to about 10 percent after the Global Credit Crisis.

Most scholars believe that the economic situation in the world is such that structurally there can only be one way in which this mismatch between valuation weights and GDP weights can be erased. The valuation weight of Emerging Markets has enormous potential to go up via the combined effect of higher stock market returns and more new stock market introductions through IPOs (Initial Public Offerings) on the one hand and a reduced risk level when their economies become less sensitive to international import-export related factors due to growth of their domestic demand from spectacularly growing local middle classes on the other. True, risk levels in Emerging Markets will remain higher than those in most developed nations. But proper stock selection and portfolio construction will help reduce the risk differential.

Figure 1 below shows the poster of an international conference organized by the French consulate in Beijing, China in November 2008. Illustrative: that is more or less at a time when Western nations were plagued by one of their deepest crises.

Figure 1 Top Firms in Emerging Markets: Global Challengers?

Governance as a Risk Factor
But when investing in Emerging Market stocks at the individual firm level investors do have to take into account that governance rules are less developed than in developed nations. At the country level, legal systems ('legality') and the 'judicial efficiency' are not as developed yet. This will have an impact on ownership structure, dividend payout, availability and cost of external finance, protection of minority shareholders and market valuations. And then there is also corporate governance at the individual firm level. Within every country there are differences in rules and regulations and the way in which they are applied (even when a specific set of rules and regulations is the same in two separate firms!) when looking at individual corporations. Adding to this agency-related issues between firm management and shareholders that have a valuation impact in every country in the world, investors do definitely want to have a clear picture of these issues at the individual firm level before investing internationally. And that is especially true when investing in less developed markets.

For smaller investors these issues will translate into a situation in which investments in individual firms are probably too risky for them. They do not have the portfolio size to create a portfolio of 20 or more individual firm holdings. Larger investors, e.g. specialized mutual fund investors, can of course still contemplate investments in individual firms that will have the potential to be a regional or even global challenger. True, the aforementioned factors do provide substantial risks, but firm valuations are relatively lower than similar growth stories in nations with a more developed governance structure at the combined country/firm level. Only to the extent that valuation discounts are not in line with differential governance-related risks can we say that these markets are 'too risky'. And that is not the case. Some of the best track records of the last 10-15 years in international investing have been generated by specialists in Emerging Markets investing. No surprise when looking at the macroeconomic structural potential of these markets. But we do need to analyze governance at the firm level carefully, especially when taking into account that most foreign investors will probably be minority shareholder in an Emerging Markets firm.

Governance at the Firm Level
Klapper and Love (Worldbank, 2002) study governance in Emerging Markets at the individual firm level. They do so by linking differences in corporate governance levels between firms to differences in operational performance and stock market valuation. In their analysis they correct for sectoral/industry and country differences in governance levels.
Logo of the World Bank

The two World Bank authors conclude that firm-level governance differentials are more important in countries with weaker legal environments when looking at governance. But note: the average firm in a country with weaker governance structure at the macro level does have weaker governance and lower performance (be it operational or market valuation) than their colleagues from a country with better governance structure. In other words - and in line with our conclusion in Part 1 (see previous blog entry) - governance is a factor, both at the firm and country level, but the relative importance of the variable is larger in less developed Emerging Markets. It is a valuation element that plays a larger role when studying Goldman's Next-11 or the Frontier Index than when trying to pick the best stocks in some more developed nations. In table 1a, 1b and 1c we present three groups of developing countries categorized by their LMG Governance Ratio. We refer to Part 1 of this contribution for more details about the Ratio.

Each group has more than 50 nations, not all of which are equally important in terms of stock market investing.

Table 1a LMG Governance Ratio 2009
Category 'Best Governance Em Markets'
(Brigher Green = Important Markets for Investors)

The countries in the brighter green-colored cells are more important for investors. Among them are two of the BRIC nations (Brazil and India), and some of the largest countries in the MSCI Emerging Markets index like South Korea, Taiwan, Malaysia, Israel, South Africa, Turkey, Thailand. Out of the 51 nations in this category 17 are important investment markets, i.e. 33.3 percent.

Table 1b presents the results for the 'average' governance category.

Table 1b; LMG Governance Ratio 2009
Category 'Average' Governance Em Markets
(Brighter Orange = Important Markets for Investors)
The eight brighter orange countries represent more important investment markets within this category. I.e. a total of 15.7 percent. China is classified in this 'average' governance category. In other words: you do not need the best governance category to present an incredible growth story.

Table 1c presents the list with the countries with the worst governance track record within the Emerging Markets category.

Table 1c; LMG Governance Ratio 2009
Category 'Worst' Governance Em Markets
(Brigher Red = More Important Markets for Investors)

Only 13.7 percent of the total number of countries in this category do classify as important markets for international investors. But among them is the fourth BRIC nation, Russia.

But be aware: the 'best' governance group is not necessarily a group in which all nations can be characterized as 'good' governance nations. It is a relative classification (vis-a-vis other Emerging nations). For instance, through our affiliated company LMG Rose in Trinidad and Tobago - specializing in legal services and procurement - we know that there is still a lot of work to be done in that country, before the governance system can be called 'good' in an absolute meaning of the word. But the bottomline is clear: better governance will help attract more investments from abroad. 

Back to the Klapper and Love (Worldbank, 2002) study. The authors started by taking information from a corporate governance study done by Credit Lyonnais Asia (CLA). The CLA study consister of 57 questions of the yes/no type, categorized into 7 categories:
  • Discipline (15% weight)
  • Transparency (15%)
  • Independence (15%)
  • Accountability (15%)
  • Responsibility (15%)
  • Fairness (15%)
  • Social Awareness (10%)
CLA studied the governance levels of 495 stockmarket-listed firms in 25 emerging nations. Klapper and Love (Worldbank, 2002) did on the one hand point their finger on some research weaknesses of the CLA study, but concluded that they were not so big as to make the CLA Governance Ratios worthless. They modified the ratio and applied it to a group of firms for which they were left with a large enough number of annual observations so as to be able to link governance to performance. This left them with 374 firms in 14 developing countries, namely: Brazil, Chile, Hong Kong, India, Indonesia, South Korea, Malaysia, Pakistan, Philippines, Singapore, South Africa, Taiwan, Thailand, Turkey. Singapore and Hong Kong can hardly be called 'Emerging' anymore and the tilt towards Asia is far bigger than what it would be if the study were repeated today. But nevertheless, we believe that the World Bank scientists did an excellent job in analyzing the linkage between governance and performance at the firm level.

Contrary to the original CLA study they performed statistical regression analyses in which governance ratio outcomes were directly linked to performance indicators like Tobin's Q and Return-on-Assets. The Tobin's Q ratio is like a Price/Book valuation ratio, but now at the overall firm and not just equity level. It is defined as:
The authors performed sets of regressions in which levels of performance indicators were explained using the Governance Ratio (firm-level governance), country and sector dummies and country-level governance indicators like judicial efficiency, legality, shareholder rights levels according to laws and stock market regulations et cetera. They also corrected for 'size' - measured by the natural logarithm of Sales Revenues -, fixed assets / sales (based on the assumption that governance control is more complicated in firms with less tangible capital) and sales growth (based on the assumption that firms with faster sales growth need more external capital and might therefore be more prone to comply with certain governance standards).

The linkage between the country level governance variables and firm scores were high, but still for more than 60 percent unexplained. This implies that one of the first important conclusions would have to be that firms do have space to add value via their own corporate governance policy. The authors also confirmed the hypothesis that firms with higher past sales growth rates were indeed the ones that seemed to have better corporate governance. The increased need for additional capital did make firms understand the possibility of expanding the pool of potential investors through better corporate governance rules and regulations. The hypothesis concerning the percentage of fixed assets in a firm was also confirmed. On average governance was poorer in firms with a larger percentage of fixed assets.

The size-related control variable was not so important, after controlling for sales growth and fixed capital intensity. Actually when looking at the track record of the best mutual fund managers in Emerging Markets, it is clear that the winners do normally buy smaller firms than the winners! Big is not necessarily more beautiful in Emerging Markets. This is quite similar to the Small Firm Effect on exchanges in the developed world.

This leads us to an interesting intermediate conclusion:

Although most scholars tell us that developing countries will gain tremendous market share in manufacturing industries - most of the time very (fixed) capital intensive firms - from a valuation perspective (when looking at the largest firms in Emerging Markets) the safest success stories for foreign investors are not to be found in these industries but rather in growth firms in less capital-intensive industries! 

Klapper and Love (Worldbank, 2002) conclude that a one standard deviation increase in Governance ratio translates into a 23% percent higher market valuation in terms of Tobin's Q ratio.

As stated earlier, the authors made sure that they controlled for country-level governance indicators. They also included interaction terms that were statistically significant, thereby making it clear that firm-level governance measures did indeed make a difference and that this was even more the case in a weaker legal environment.

However, the authors proceeded by stressing that this was all relative. I.e. good governance at the firm level can never ever be a replacement for good governance policy at the country level. To some extent the two will go hand in hand, when governments will see that more successful firms are the ones that worked harder on their corporate governance policy.

Investors who want to invest in Emerging Markets at the individual stock level should take into account what type of corporate governance policy a firm is following. The Credit Lyonnais Asia questionaire used by Klapper and Love (Worldbank, 2002) provides the analyst with a good starting point. The complete list with the 57 Yes/No type questions can be found in an appendix to the Klapper and Love paper. If you want to receive the Klapper and Love paper, feel free to contact LMG at

Better corporate governance translates into a higher valuation and - assuming that most of you are not buying Emerging Markets stocks to acquire majority shares - this is very important. However, differences in valuation levels are also related to country- and sector-level variables. When filling an Emerging Markets portfolio at the global or regional level this should be taken into account as well. Firms with more impressive sales growth track records and a capital structure with a larger percentage of intangibles are more likely to have better governance. You cannot assume that 'size' is a positive indicator. When analyzing the biggest firms on a developing stock market don't translate 'sheer size' into something like 'well, they are so big, they will probably not fool me through measures that are not in the interest of minority shareholders; how could they be so big if they weren't playing things by decent, legal rules?'. This is not true! Size - as measured by the natural logarithm of Sales Revenues - was not a factor of significance.

Last but not least: the Klapper and Love study is now 7 years old. Eastern European nations were not included and neither was China. The LMG Governance Ratio indicated that these were nations in the 'average' and 'weak' governance groups of our - more recent - LMG classification. With Singapore and Hong Kong not being in our 'Emerging' definition anymore, 9 out of 12 countries in the Klapper and Love study are part of our 'best' governance category. This implies that - based on their conclusion that results are stronger in countries with lesser quality governance systems - positive valuation effects based on corporate governance differentials will most likely be even stronger when moving from the 'best' governance to the 'average' and 'weak' governance categories. Especially for investors interested in bargains in Frontier or lesser developed Emerging economies 'corporate governance' will therefore be an important indicator.

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