Why corporate governance is vital in Asian stockmarkets
In late March investors in Huishan Dairy, a Chinese dairy group listed in Hong Kong, watched on in disbelief as shares in the company plunged.
For those on the lookout, the warning signs were already flashing months prior: high levels of unsustainable debt and question marks surrounding management practices.
Those who were caught off guard were left nursing an 85% loss.
The tale shows the importance of a focus on corporate governance in the region.
Focusing on the “G” in Asia
So how do we, as active investors, judge companies in this realm? Although the hot topic for investors in many developed markets is environmental, social and governance (ESG) issues, in Asia the “G” of governance is our top priority.
If you cannot trust management of a company, you are inherently unable to trust the board of the company to take the right steps to create long term shareholder value. Ensuring that management and shareholders’ interests are aligned is the starting point.
For example, on the whole the Schroders Asia ex Japan Equities Team generally avoid state-owned companies (SOEs) in Asia; purely because the companies’ interests tend to be aligned with the state and not shareholders.
Increasingly, the ways our teams in Asia view the “E” and “S” components are as indicators towards longer-term sustainable business models.
Issues that could potentially adversely impact companies on the environmental and social fronts, such as environmental scandals or product recalls, we view as an opportunity for competitors to either grab market share or an invitation for increased regulatory scrutiny. The upshot of this is that longer-term profit will not be sustainable.
Jay Luong, Fund Manager, Asia ex Japan Equities said:
“Our investment process integrates governance into how we assess whether we can invest in certain companies.
On a broader level, we look for companies that create durable long term value for shareholders. From a fundamentals perspective, this means identifying companies that have a positive ROIC minus WACC and preferably where valuations are attractive.
These are generally companies that we like to own. As we focus on the returns of a business, any governance worries – whether it is directionless strategy, hoarding excess cash, or no execution follow-up – will become immediately apparent.
Companies that invest and expand without due care for returns, we shy away from.
Other key barometers we look at for good governance include factors such as excess profits and cash flow and whether management re-invests smartly or returns these to shareholders.
Consistency and discipline in delivering a company’s medium term growth target is another positive for us.”
Model markets and dividends
Crucially, whether a company pays dividends to shareholders is also an important indicator of how robust a firm’s corporate governance is.
For the Schroders Asia ex Japan Equities Team, it's a sign of management’s ability to plan, execute and stay disciplined on targets and budgets.
The Asia Pacific region boasts some examples where governance is well-entrenched in corporate processes. One such country is Australia where the market is transparent and more developed.
For example, the Australian Stock Exchange (ASX) has a code of conduct that it asks all listed companies to publish, acknowledging whether they adhere to the code or not.
Clearly, other markets in Asia are improving and there are encouraging signs of progress.
Jessica Ground, Global Head of Stewardship, ESG said:
“We have been engaging policymakers on the issues, most recently the International Organization of Securities Commissions.
In October 2016 it published its Report on Corporate Governance in Emerging Markets identifying practice measures that local regulators can implement to improve the environment.
Schroders was one of three asset managers who fed into this report. The work concluded that the focus should be on improving board quality and accountability, ensuring remuneration creates long term value, as well as improving risk management framework and internal controls. “
In Korea, for example, the expected adoption of a Stewardship Code over the next 12 months bodes well for a market that has traditionally been miserly in terms of dividend payout ratios3 and dividend yield4 (see below).
Optimism should be tempered by the fact that the recent trend of increasing dividend payouts and share buybacks in Korea has been driven by only a small number of bigger Chaebols (large family-owned Korean conglomerates).
However, there are real hopes that corporate governance and capital efficiency will show some tangible improvement.
This is being driven by expectations that institutional investors will adopt the code and be more transparent in how they exercise their voting rights.
Small steps such as these increase visibility and transparency for investors. Ensuring corporate governance of any company is on a sound footing is the ideal starting point for investors seeking to be fully informed (and reassured) about their investment decisions.
1. WACC is the rate that a company is expected to pay on average to all its security holders to finance its assets. It is commonly referred to as a firm’s cost of capital.↩
2. Return on invested capital is a financial ratio used to measure profitability and value-creating potential of companies after taking into account the amount of initial capital invested.↩
3. The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount of total net income of a company.↩
4. A financial ratio that indicates how much a company pays out in dividends each year relative to its share price.↩