Emerging Markets Equities

Alignment of interests in emerging markets

The “principal agent problem,” also known as the “agency problem,” has existed since the dawn of civilization. There is a fundamental issue when the ‘agent’ is authorized to make decisions on behalf of the ‘principal’.
August 2019

The “principal agent problem,” also known as the “agency problem,” has existed since the dawn of civilization. There is a fundamental issue when the ‘agent’ is authorized to make decisions on behalf of the ‘principal’. In many cases, from shareholders (principals) vs. corporate managements (agents) to voters (principals) vs. politicians (agents), this problem persists. It can come in many forms and it leads to what economists call moral hazard or a conflict of interest.1 As asset managers, we face the agency problem when allocating our clients’ capital. We have taken steps to ensure full transparency and strong alignment through co-investing with our clients, as well as appropriate incentive structures and a long-term mindset. We believe strong alignment is a very important mechanism in ensuring pain and success are mutually shared. When we invest in companies, we use this same mindset, looking for an alignment of interests with the management teams and owners of these businesses.

Before we delve further into how we think more broadly about alignment, it is important to highlight some of the key characteristics of our investment universe. Two types of majority shareholders are prevalent in emerging markets (EM) listed equities: families and governments (we will refer to them as State Owned Enterprises, or SOEs). In Indonesia, for example, family-controlled companies make up 50% of the MSCI listed equities, and a further 42% are SOEs, according to Morgan Stanley. This picture holds true across the majority of the emerging markets, with some differences such as China having a larger proportion of SOEs and South Korea being dominated by family-owned “chaebols,” etc. In contrast to the EMs, family-owned businesses make up only one-third of the S&P 500 Index. For the Responsible Global Emerging Markets strategy, family-owned businesses make up more than 50% of our holdings, and 80% of our total holdings have a steward with a significant shareholding in the businesses.

For us, investing is about being shareholders in real businesses — not a flashing Bloomberg ticker on a screen but actually partly owning businesses with employees, assets and stakeholders, where we aim to partner with those in charge. This means we aim for our interests (as minority owners) to be aligned with those of the majority owners, whether families or governments. Both types of owner carry different merits that we find attractive, and we are also fully aware of the risks involved in partnering up with a controlling shareholder.

 

Family businesses

Many family businesses have been able to deliver consistent profitability, more so relative to non-family-controlled peers. Credit Suisse research on the topic has demonstrated that family-owned companies have managed to outperform broader equity markets by 4% per year since 2006.3

At LGM, we find that certain qualities in family businesses fit well with our investment approach. Families typically aim to retain and grow their businesses for many generations to come. Often, a family’s main source of wealth sits with the listed company, creating a strong and tangible alignment of interest with minority shareholders that also have a long-term mindset. We believe the family businesses we invest in demonstrate characteristics that go beyond pure entrepreneurship to involve perseverance, ambition, passion and, importantly, integrity.

In order to ascertain whether a business has the above-mentioned qualities, we undertake extensive due diligence on the owners. We seek to understand the reasons for their success, including whether this is largely linked to political connections rather than leadership, entrepreneurialism and good management. Political connections can generate value, but are a risky and potentially circumstantial intangible quality that we do not think can be sustainable, especially when political winds change. We like businesses that do well regardless of the prevailing political backdrop.

Another element we analyze carefully is family relationships. Conflicts in families are unavoidable and family businesses can compound these challenges even further. Therefore, we evaluate approaches to communication and conflict resolution when it has arisen, formal governance structures, and succession planning.

Family-controlled businesses as a whole contribute to an estimated 70%–90% of the global GDP and 50%–80% of jobs in the majority of countries worldwide. (2)

We also assess related party transactions (RPTs) to make sure material RPTs do not disadvantage minority shareholders; ideally, companies will have fully independent audit committees that responsibly ensure that such transactions are conducted based on arm’s-length valuations. We recommend that each company disclose any shareholdings that its controlling owners may have in other companies or investment vehicles that have a material interest in the company. Some companies tend to have overly complex structures that at times can look a lot like a disorganized spider web — we avoid companies with these structures given the significant governance risks involved.

Another key part of our analysis involves understanding how families have behaved in past crises. This provides us with a good picture of attitude towards risk and how they treat minority shareholders when it matters the most.

 

State Owned Enterprises (SOEs)

We are generally very cautious about investing in SOEs as these structures add a layer of governance challenges on top of those that any listed firm already faces. These challenges often arise when the alignment of interest between value creation and “national service” gets blurry (which is more common than not). By “national service”, we are referring to states’ political, economic and social agendas, e.g., securing an election, fostering local enterprises or keeping unemployment low. While we don’t impose a blanket ban, when we find an SOE company we like we spend a lot of time researching and understanding where we stand as minorities and whether we could benefit from the success of the company.

We find that SOEs are of mixed quality across Asia. On one extreme we observe companies staying loyal to the state regardless of cost. An example is one of the largest Asian oil and gas (O&G) companies (part of the MSCI EM Index), which controls almost two-thirds of the mid-stream gas infrastructure and is mandated to ensure abundant domestic supplies, even if doing so means selling gas at a loss. There certainly are beneficiaries of such operations, but we feel minority shareholders will not always be one of them.

On the other side of the spectrum, we have our holding China Resources Gas (CR Gas), which distributes natural gas to households and industries across China (“downstream” in O&G jargon). We feel this company is strongly aligned to minority shareholders as well as to the Chinese government. As China continues to invest in trying to improve air quality by using alternative sources of energy instead of coal, CR Gas has pledged to connect houses, businesses and factories to the natural gas grid. In order to attract investments, it offers fair contracts to private and public companies and, as a result, is positioned favorably to reap the benefits from the clean energy transformation as one of the largest natural gas distributors in the country. It generates very large and growing free cash flow and, as a result, its dividends and pay-out ratio have increased every year. We believe it is also reasonably valued, justifying risk and reward. While our research gives us ample comfort in investing in CR Gas, we are also wary that policies can change, and not always in favor of investors. Therefore, we have decided to ensure our exposure is moderate, with around 1.5% of the strategy currently invested in CR Gas.

Engagement update

Managing environmental and social risk

Banks are exposed to credit, reputational, legal, operational and market risks driven by environmental and social (E&S) issues that affect their clients and customers. Identification and management of these risks as part of their credit risk appraisal processes is, therefore, important for banks to manage their exposure to overall risk. This quarter we engaged with several of our holdings, including Bank Mandiri, HDFC Bank, Kasikornbank and Public Bank, to encourage them to strengthen their E&S-specific procedures, assessment tools and internal capacity allocated to managing these risks. In particular, we asked them to identify and report on portfolio-level E&S risks, monitor clients’ E&S performance and require them to implement mitigation measures for identified E&S risks, and develop specific guidance on industries with potentially high E&S impacts, e.g., extractives, coal-fired power generation, agriculture.

Several studies point to the significant impact on global greenhouse gas (GHG) emissions caused by the forecasted growth in milk consumption in China: according to one study4, global emissions from Chinese dairy production alone could increase by 35% and the land needed to feed cows for China would have to increase by 32% in the next 30 years.

Our holding, Yili, is China’s largest dairy company and now amongst the top 10 globally. During the quarter, we had a productive discussion with the company, during which we expressed our support for several initiatives it has taken over the past couple of years to mitigate GHG emissions along the entire value chain. These initiatives, which include energy efficiency measures and cooperation with farming partners to implement sustainable dairy farming practices, led to an 8% reduction in carbon emissions per ton of product between 2016 and 2018. At the same time, we encouraged Yili to step up its efforts to collect, measure and report emissions, and engage with suppliers and other stakeholders to drive increased efficiencies in milk production in China.

 

Portfolio actions and considerations

During the quarter, we initiated a new position in Bajaj Auto, a leading manufacturer of two- and three-wheeler vehicles in India. We believe Bajaj has a wide economic ‘moat’ (competitive advantage) with its strong global franchise, able management team and solid balance sheet, and superior profitability ratios. Bajaj has a large presence in India and has built a strong franchise across markets in southeast Asia, Africa and Latin America.

In India, Bajaj has historically been a leading player in the premium segment of the motorcycle market. Over the past eighteen months, the company has reset its domestic strategy in order to increase market share in the entry level and main commuter segments of the market, through new products and more attractive pricing points. This has enabled the company to increase market share, although further progress needs to be made in the main commuter segment. Interestingly, the company is the first major Indian manufacturer looking to launch electric two- and three-wheelers in India over the coming 6-12 months. Given concerns over increasing carbon emissions, we think this could potentially be an interesting long-term growth area for the company.

The key sustainability argument for Bajaj is around mobility. In rural India (or any rural emerging market) public transport infrastructure is often a mix between weak to non-existent. We see Bajaj as playing a key part in helping people’s mobility by providing a cheap and efficient method of transportation. Even in cities, the above statement is true as motorbikes generally don’t require as much fuel nor take up as much space (traffic) as cars. Combined with the fact that the business is strong (net cash), has a decent export element, and is led by a reputable trustworthy family, we feel comfortable in our initial investment.

We also initiated a position in Chile’s Aguas Andinas. Majority-owned by Suez, a leading water and waste management company, Aguas is a regulated water utility company that manages the whole water cycle, including: the catchment of raw water, water production, transportation and distribution, and the collection, treatment and final disposal of sewage. In addition to providing clean water, the company has built a circular economy by setting up a bio factory where the energy recovered from sewer sludge leads to the production of electricity, natural gas, and thermal energy, and bio solids from the wastewater treatment plants are reused as fertilizer to grow food.

The business is very well positioned from a sustainability point of view. It continues to improve efficiency through investments in minimizing leakage, invests in improving customer service, and has implemented water management programs to promote the development and social inclusion of the most underprivileged areas across Chile. In the context of the country’s exposure to increasing water stress from climate change, Aguas’ ability to efficiently provide clean water while also implementing a strategy focusing on the circular economy are key qualities for the long-term health and sustainability of the business whilst ensuring drinking water for the masses at affordable prices.

 

Final note

As it stands, year-to-date to the end of June 2019, our portfolio has caught up with the benchmark (the MSCI Emerging Markets Index) and has on an absolute basis managed to grow by more than 10% in USD terms; overall we feel the increase in absolute value is what matters for the most part. While valuations remain somewhat elevated we have been finding pockets of interesting long-term ideas. We will keep our investors informed as we dig deeper into the financial and sustainability elements of these companies.

These purchases were funded from reductions in HDFC Bank, Vitasoy, Bank Rakyat Indonesia and China Resources Gas, and the sale of Western Union, which is facing increased competition in the international payments and money transfer market, including from newly established financial technology companies.

Related Capability

Learn more about our Emerging Markets Equities capabilities.

1 Defined as a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.

2 https://www.ey.com/gl/en/services/growth-markets/family-business/ey-women-in-leadership-the-family-business-advantage

3 Around 1000 family owned companies worldwide followed by Credit Suisse analysts with over $250m market capitalisation. https://www.credit-suisse.com/corporate/en/articles/news-and-expertise/the-family-business-premium-201809.html

4 “Global environmental costs of China’s thirst for milk”, Zhaohai Bai Michael R. F. Lee Lin Ma, Gerard L. Velthof, et.al, Wageningen University and Research, February 2018

All investments involve risk, including the possible loss of principal. Past performance does not guarantee future performance.

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management. The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

The LGM Responsible Global Emerging Markets Composite includes all discretionary portfolios managed according to LGM’s Responsible Global Emerging Markets ESG (Environment, Social and Governance) Strategy. Portfolios within the composite are managed and measured against the MSCI Emerging Markets but are restricted to investing in companies that demonstrate a clear link to sustainable investment. The benchmark is MSCI Emerging Markets (Total Return) Index. MSCI Emerging Markets Index is a market capitalization weighted index comprised of over 800 companies representative of the market structure of the emerging countries in Europe, Latin America, Africa, Middle East and Asia. Investments cannot be made in an index.

The S&P 500® Index is an unmanaged index of large-cap common stocks.

This presentation may contain targeted returns and forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may,” “should,” “expect,” “anticipate,” “outlook,” “project,” “estimate,” “intend,” “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such returns and statements, as actual returns and results could differ materially due to various risks and uncertainties. This material does not constitute investment advice. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The mention of specific securities or products is for informational purposes only and is not intended as a recommendation to buy, sell or hold any security or product.

Dividends are not guaranteed and are subject to change or elimination.

Related articles

No posts matching your criteria