Four red flags for informed investing in emerging markets

Some years ago, during a fact-finding trip to what was then a leading emerging market (EM), I visited a company that was attracting significant interest from investors. It proved to be an eye-opening encounter, to say the least.

I arrived to discover a car-park populated by shiny supercars. The reception area was swathed in marble, while every room was festooned with fashionable works of art. I was duly introduced to the CEO, who oozed charm, sophistication and confidence.

Well, so much for surface appeal. Further scrutiny and dialogue exposed the business as poorly positioned in its market, badly run and inadequately prepared for the future. The CEO’s smooth-talking shtick belied cavalier management and a balance sheet saddled with substantial debt.

As a rule, a Ferrari or two, a taste for dazzling décor and a captivating spiel do not outweigh lousy fundamentals. Accordingly, it was deemed prudent not to invest. The company subsequently vanished into the dustbin of corporate history.

Similar tales can be found throughout the world of investment, of course. Yet they tend to be more prevalent in EMs, which – albeit often undeservedly – have a reputation for being unusually wild, challenging and opaque.

This goes a long way towards explaining the importance of having an on-the-ground presence and dealing directly with EM businesses. But what are the key “red flags” that specialist investment teams look out for in these varied and sometimes unfamiliar settings?

1) ‘Creative’ balance-sheet management

This shortcoming can range from the deliberately disingenuous to the ill-advised. The latter description might politely be applied to EM companies that choose to take on foreign currency debt.

Assuming debt in, say, US dollars can make sense for a business that has international operations and, as a result, generates dollar revenues. For those focused on domestic markets, however, this kind of ploy can lead to a major blow-up if the chosen currency suddenly rallies.

Such a turn of events has sealed the fate of numerous otherwise perfectly sound EM companies. Some have been forced to surrender to buyouts, while others have been left with no option but to fold. Financial engineering can make return ratios point to all the right things, but it can also invite a lot of trouble.

2) Substandard governance

Traditionally, governance standards in EMs have been viewed as rather less than ideal. Today – not before time, some investors might say – many of these economies are taking steps to bring about meaningful reform.

In Asia, where we invest, South Korea’s Corporate Value-up Program is among the most notable initiatives. Officials have billed it as a vehicle for radically transforming the nation’s capital markets. China is also urging companies to adopt more shareholder-friendly polices.

Yet it is far from safe to suppose every business will dutifully toe the line. Such an assumption would be misguided even in developed markets. In our experience, in-person meetings with management can be the most effective means of learning who is walking the walk and who is merely talking the talk.

3) Deficient structure

This is a concern that is closely related to the broader issue of governance. Especially in Asia, a practice known as cross-shareholding frequently sets alarm bells ringing among knowledgeable investment teams.

Cross-shareholding involves companies holding shares in their business partners or associates. In many instances this long-controversial approach is underpinned by ownership models dominated by wealthy families that have no incentive to upset the status quo and are therefore determined to retain majority control.

Crucially, there are some family ownership structures that do lend themselves to sustained success. In tandem, there are some management-led corporations than can promote unhealthy short-term thinking. Again, this is why there is merit in engaging on a face-to-face basis and digging deeper.

4) Superficiality versus reality

This brings us back to our friends with a firm fondness for marble. Needless to say, the lesson here is that appearances can be deceptive. As in The Wizard of Oz, what you are allowed or encouraged to see might not reflect what actually lurks behind the curtain.

Interestingly, though, it is not always a case of style over substance. Particularly at the lower end of the market-capitalisation spectrum, there are also occasions when something ostensibly unimpressive turns out to be genuinely worthy of attention.

India serves up plenty of these pleasant surprises, with many HQs that might best be thought of as gloriously ramshackle revealed to house excellent businesses with strong long-term prospects. This is just one reason why Asian EMs are home to so many “hidden gems”.

Gabriel Sacks is investment manager, abrdn Asia Focus plc.

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