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.

Research Team
EM Alpha LLC

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About EMAlpha:

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.

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