Emerging Markets and Importance of Managing the Corporate Governance Risk
You can trade anything you want as long as there is a willing buyer or a seller. For any company which is listed and had enough trading volumes, you can buy or sell the stock whenever you want. But to avoid unpleasant surprise, we need to apply a Corporate Governance filter first and then only trade those “good quality” stocks. Another somewhat similar way is to look at the stocks through ESG (Environmental, Social and Governance) framework and then decide what you can invest in and what you should avoid. In EMs especially, that is as important as tracking news flow, understanding investor sentiment or analysing financial statements.
It is often said that in the markets to succeed, the first learning needs to be…how to minimize mistakes. When people are excessively focused on finding the winners, they often lose light of losers in their portfolios. But, what to do when you encounter something like ENRON in USA or SATYAM in India. The massive accounting frauds and irregularities in reporting of financial statements could hit you when you least expect them. They don’t get covered in news flow, you won’t find them in sentiment analysis and in short, there is no warning before the event.
Something similar has happened in India with CG Power and Industrial Solutions Ltd. The shares of CG Power and Industrial Solutions have tumbled 36% in the last two trading sessions on news of serious accounting lapses at the company. The stock has been hitting the lower circuit for the past two days because no one knows the extent of the trouble at the company. The fall would have been more had there been no circuit i.e. the losses in the stock are capped at 20% for a day which means that as soon as the stock hits 20% lower price than yesterday’s close, the bids to sell don’t get accepted anymore. It is simple, there are no buyers in the market for the name, only sellers.
Of course, the market, to some extent knew that all is not well with CG Power and Industrial Solutions Ltd (erstwhile Crompton Greaves). The company’s market capitalization has declined from around ₹60 bn in January 2018 to ₹11.5 bn crore earlier this week, even before it reported the problems on Tuesday. The troubles for the company began when between 2006 and 2010, Crompton had acquired several firms in the UK, France, Ireland, Belgium and Hungary and the strategy to grow inorganically didn’t actually work. Butthat is not the point. The business decisions might go wrong as future is unpredictable.
The bigger problem is intent and whether it was under a serious question mark. The problems remained hidden for so long and no one actually bothered is not just a problem with one company. It reflects very poorly on how things went unnoticed for so long and to what extent, the corporate governance was compromised. It may not entirely be a problem of Emerging Markets (EMs), but it is a fact that the investors need to be more circumspect while investing in EMs. There are challenges of inadequacies in legal and regulatory framework, but the compliance part is a much bigger issue. The judicial process is lengthy and conviction rates are low for white collar crimes.
There are of course, no fool proof methods to figure out who is more at risk and which companies are a big No-No from corporate governance risk standpoint. But there are certain red flags which an investor need to keep an eye on, a) when the business performance is ‘too good to be true’ and especially in situations when the other companies in sector are doing poorly, b) the accounting norms are shrouded in mystery on critical items, c) too much of unnecessary acquisition and diversification, and at prices which are on the higher side. The prevailing sentiment among local investors about a company and news flow are also important yardsticks to measure and assess this risk.
The law will always remain a step behind crooks but there is certainly a need for introspection among the Governments, Market Regulators and Investors in EMs to minimize the damage from corporate governance lapses. More we work on this; more investible EMs will become.
EM Alpha LLC
For more EMAlphainsights on Emerging Markets, please visit https://emalpha.com/insights/. To know how you can use EMAlpha’s unstructured data on Emerging Markets for better investment decisions, please send us an email at [email protected].
EMAlpha, a data analytics and investment management firm focused on making Emerging Markets (EMs) accessible to global investors and unlocking EM investing using machines. EMAlpha’s focus is on Unstructured Data as the EMs are particularly susceptible to swings in news flow driven investor sentiment. We use thoroughly researched machine learning tools to track evolving sentiment specifically towards EMs and EMAlpha pays special attention to the timely measurement of news sentiment for investors as these markets can be finicky and sentiment can be capricious.Our team members have deep expertise in research and trading in multiple Emerging Markets and EMAlpha’s collaborative approach to combining machine learning tools with a fundamental approach help us understand these markets better.
This insight article is provided for informational purposes only. The information included in this article should not be used as the sole basis for making a decision as to whether or not to invest in any particular security. In making an investment decision, you must rely on your own examination of the securities and the terms of the offering. You should not construe the contents of these materials as legal, tax, investment or other advice, or a recommendation to purchase or sell any particular security. The information included in this article is based upon information reasonably available to EMAlpha as of the date noted herein. Furthermore, the information included in this site has been obtained from sources that EMAlpha believes to be reliable; however, these sources cannot be guaranteed as to their accuracy or completeness. Information contained in this insight article does not purport to be complete, nor does EMAlpha undertake any duty to update the information set forth herein. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information contained herein, by EMAlpha, its members, partners or employees, and no liability is accepted by such persons for the accuracy or completeness of any such information. This article contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of certain investment strategy. All are subject to various factors, including, but not limited to, general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting the operations of the companies identified herein, any or all of which could cause actual results to differ materially from projected results.