Global Markets Strategy September 2, 2015 Focus Report Gauging Governance Globally: 2015 Update A Governance Update With some observers attributing recent volatility in EM equities in part to governance issues, we update the analysis in our 2014 report. Weakening Governance Generally The percentile ranking of two-thirds of the countries in a governance composite declined in 2015 versus 2014. Curraheeshutter/Crystal Graphics Governance Even More of an Issue in Some EMs Many Emerging Markets saw a notable deterioration in various governance metrics, including national governance (corruption in China and Russia) and corporate governance (India). Paradoxically, as some EMs seek to boost economic growth, it may be the case this only weakens governance more corruption, an undermining of corporate ethics, etc. Worrisome Trends Given that the quality of country-level governance affects corporate governance and, thus, firm value, some valuations could be at risk of downward readjustment should governance weaken further. Strategy Implications Governance trends are one of the reasons why we are Underweight Latin America, India, Russia, China in our regional strategy model. Figure 1: The Cornerstone Capital Governance Composite: Ranking 2015 vs. 2014 Michael Geraghty Global Markets Strategist 212-874-7400 Source: Cornerstone Capital Group
The Impact of National and Corporate Governance on Country Valuation At its most fundamental, the valuation of a country s financial assets is a function of its long-term potential economic growth, which, in turn, is dependent on a number of variables, including Environmental, Social & Governance (ESG) factors. So, for example, in an analysis of sovereign credit risk, the United Nations Principles for Responsible Investment (PRI) noted 1 that: Environmental factors showed the weakest correlations with sovereign bond performance in studies carried out by AXA Investment Its research showed correlations between returns and governance and social ratings, but showed a weaker link to environmental issues. In our September 15, 2014 report Gauging Governance Globally: Macro and Micro Metrics we referenced another PRI report 2 that focused specifically on ESG factors and equity valuation, and we highlighted the assertion that: The importance of considering both national and corporate governance has increased in recent times. It has become more apparent as investors have sought to profit from growth in developing and emerging markets where lack of transparency and underdeveloped legal structures exist [italics added]. The quality of country-level governance affects corporate governance, and thus, firm value In terms of the significance of national governance for corporate valuations, a recent academic study 3 stated that: The quality of country-level governance affects corporate governance and, thus, firm value [italics added]. Governance at the National Level Two main proxies for country-level governance were used in the aforementioned academic study: 1) Contracting institutions, which refer to the rules and regulations governing contracting between two parties of similar power, such as those between creditor and debtor. 2) Property rights institutions, which refer to the rules and regulations protecting market participants against the power of the government. Measures of property rights include (i) constraints on the executive (i.e., whether there are regulatory limitations on its actions and authority); (ii) protection against the risk of expropriation of private foreign investment and; (iii) private property protection. 1 Sovereign Bonds: Spotlight on ESG Risks 2013 2 How Investors Are Addressing Environmental, Social and Governance Factors in Fundamental Equity Valuation, February 2013 3 Mutual Funds and Information Diffusion: The Role of Country-Level Governance, Review of Financial Studies 2014, Lin, Massa and Zhang, July 2014 2
A significant conclusion of the analysis was that: For countries with poor governance, advances in institutions in either property rights [that constrain governments and expropriation by the elite] or [private] contracting quality are a necessary condition to further improve their financial markets Firms invest less in corporate governance in countries with poor institutions [italics added]. In less developed countries, firm characteristics explain almost none of the variation in corporate governance ratings Similarly, another academic study 4 concluded that: Firm characteristics explain almost none of the variation in [corporate] governance ratings in less-developed countries [with] corporate governance [dealing] with the mechanisms that ensure investors in corporations get a return on their investments. In our 2014 report, we utilized The World Bank s Worldwide Governance Indicators as a measure of national governance. These indicators, which measure the traditions and institutions by which authority in a country is exercised, report annually on six broad dimensions of governance for 215 countries: Voice and Accountability: This indicator captures perceptions of the extent to which a country's citizens are able to participate in selecting their government, as well as freedom of expression, freedom of association, and a free media. Political Stability and Absence of Violence: This indicator measures perceptions of the likelihood of political instability and/or politically motivated violence, including terrorism. Government Effectiveness: This indicator captures perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government. Regulatory Quality: This indicator captures perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development. Rule of Law: This indicator captures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. Control of Corruption: This indicator captures perceptions of the extent to which public power is exercised for private gain, including both corruption, as well as capture of the state by elites and private interests. 4 Why do countries matter so much for corporate governance? Journal of Financial Economics, Doidge, Karolyi and Stulz, 2007 3
Figure 2 illustrates that the updated R-squared of The World Bank s Worldwide Governance Indicators and country P/E multiples is unchanged at 0.07. (Note that we again utilize the methodology of our 2014 report, whereby we only plot data for the 33 countries with the largest weightings in the MSCI All Country World Index, and with their percentile ranking being relative to all the other countries in the relevant sample.) With regard to governance at the national level, there was no material change in the year-on-year percentile ranking of any of the 33 countries Somewhat worryingly, however, there was no material change in the year-on-year percentile ranking of any of the 33 countries in the updated analysis. In other words, there was little evidence of any improvements in national governance that might have positive implications for corporate governance, particularly in less-developed countries. Figure 2: Country P/E vs. Average World Bank Governance Index Percentile 2007-2013 Source: World Bank and Cornerstone Capital Group Corruption Perceptions: Worsening in Some EMs As noted, one of The World Bank s Worldwide Governance Indicators is control of corruption, which measures corruption among public officials, a potential cost of doing business. A separate measure of this issue covering almost 200 countries is the Corruption Perceptions Index of Transparency International, an organization that defines corruption as the misuse of public power for private benefit. Figure 3 illustrates that, for the countries in our sample, the updated R-squared of the Corruption Perceptions Index and country P/E multiples is unchanged at 0.10. 4
Figure 3: Country P/E vs. Average Corruption Perceptions Index Percentile 2007-2014 Source: Transparency International and Cornerstone Capital Group However, it was notable that, in the course of a year, two countries showed a significant deterioration in terms of perceptions of public sector corruption: Russia s percentile rank declined from an already low 24% to just 20%, while China s rank plummeted from 55% to 42%. In the course of a year, two countries showed a significant deterioration in terms of perceptions of public sector corruption: Russia, China These findings are corroborated by other studies. For example, a recent Pew Research Center analysis 5 revealed that, in both Russia and China, significantly more respondents said that corruption was a very big problem for their country as compared to crime, health care, poor schools or pollution, and concerns about corruption increased markedly in recent years Figure 4. Figure 4: Percentage Saying Corrupt Leaders Are a Very Big Problem in 2007 and 2014 Source: Pew Research Center 5 Crime and Corruption Top Problems in Emerging and Developing Countries, November 6, 2014 5
Ease of Doing Business: Little Changed In addition to costs of doing business such as corruption the ease of doing business is another factor that can potentially detract from (or add to) a country s growth rate. The World Bank Doing Business 2015 report again ranked 189 countries in terms of ease of doing business. In broad terms, this report measures regulations that enhance business activity and those that constrain it. Here, too, there was no material year-on-year change in the percentile ranking of any of the 33 countries in our sample, or in the updated R-squared Figure 5. Figure 5: Country P/E vs. Average Ease of Doing Business Percentile 2007-2015 Source: World Bank and Cornerstone Capital Group World Economic Forum Corporate Governance Score: A Micro Metric At a more micro level, the World Economic Forum (WEF) Corporate Governance score is the average of six specific scores for 144 countries that are based on a WEF Executive Opinion Survey. This annual survey captures the opinions of over 14,000 business leaders in the 144 economies on specific issues within their respective countries. The components of the WEF Corporate Governance score are: Ethical behavior of firms: In your country, how would you rate the corporate ethics of companies (ethical behavior in interactions with public officials, politicians, and other firms)? [1 = extremely poor among the worst in the world; 7 = excellent among the best in the world] 6
Strength of auditing and reporting standards: In your country, how strong are financial auditing and reporting standards? [1 = extremely weak; 7 = extremely strong] Efficacy of corporate boards: In your country, how would you characterize corporate governance by investors and boards of directors? [1 = management has little accountability to investors and boards; 7 = management is highly accountable to investors and boards] Protection of minority shareholders interests: In your country, to what extent are the interests of minority shareholders protected by the legal system? [1 = not protected at all; 7 = fully protected] Reliance on professional management: In your country, who holds senior management positions? [1 = usually relatives or friends without regard to merit; 7 = mostly professional managers chosen for merit and qualifications] Willingness to delegate authority: In your country, how do you assess the willingness to delegate authority to subordinates? [1 = not willing at all senior management takes all important decisions; 7 = very willing authority is mostly delegated to business unit heads and other lower-level managers] Figure 6 illustrates that, for the countries in our sample, the updated R-squared of the WEF Corporate Governance score and country P/Es is unchanged at 0.13. Figure 6: Country P/E vs. Mean WEF Corporate Governance Percentile 2007-2015 Source: World Economic Forum and Cornerstone Capital Group 7
The Cornerstone Capital Governance Composite Governance and environmental factors might explain over one-third of country equity valuations A multiple regression reveals that the combination of (i) The World Bank s Worldwide Governance Indicators, (ii) Transparency International s Corruption Perceptions Index, (iii) The World Bank s Ease of Doing Business Index and (iv) The World Economic Forum s Corporate Governance score again generates an R- squared of 0.16. Note here that, in our March 5, 2015 report Environmental Issues & Country Valuations: What Matters, we identified environmental factors that generated an R-squared of 0.20 with country equity valuations. Combined, it would seem that these governance and environmental factors might explain over one-third of country equity valuations. Figure 7 illustrates that, as before, we take a weighted average of the four governance measures to derive a composite governance score. Figure 7: The Cornerstone Capital Governance Composite: Change 2015 vs. 2014 Red indicates lower percentile ranking in 2015 than in 2014; green indicates higher percentile ranking Source: Cornerstone Capital Group For two-thirds of the countries in our sample, the percentile ranking in the governance composite declined in 2015 versus 2014, although most of the changes were relatively small. However, two countries at the bottom of the governance composite experienced a material shift in rank, one upward, the other downward: Russia: As noted above, in terms of perceptions of public sector corruption, Russia s percentile rank declined from an already low 24% to just 20%. However, in our governance composite, that was more than offset by a sharp increase in the country s WEF Corporate Governance percentile ranking. All six components of the WEF Corporate Governance score for Russia experienced an improvement, most notably efficacy of corporate boards and ethical behavior of firms. 8
India: In contrast to Russia, India experienced a sharp decrease in its WEF Corporate Governance percentile ranking. All six components of the WEF Corporate Governance score for India deteriorated, most notably strength of auditing and reporting standards and reliance on professional management. Governance Even More of an Issue in Some EMs As outlined above, during the past year many emerging markets saw a deterioration in various governance metrics, including national governance (corruption in China and Russia) and corporate governance (India). In that regard, it was recently pointed out 6 in the Financial Times that: The assumption that the major political features of emerging markets would converge towards the US/UK model is no longer valid, as most have moved toward less liberal forms of governance in the wake of the [2008/09 financial] crisis. The move away from liberal models of sovereign and corporate governance has been the key driver of both the deterioration in economic growth prospects and the poor returns from emerging equity markets. The dominance of state-directed models of sovereign and corporate governance in China, Russia, Brazil and elsewhere, has undermined the return on invested capital across a large part of the corporate sector, thereby reducing productivity and potential GDP growth across their respective economies. Then, too, it may also be the case that, as some Emerging Market economies seek to boost economic development, this may actually weaken governance reflecting, for example, more corruption at all levels of the economy, and a waning in corporate ethics, particularly at some family-owned businesses that have experienced rapid growth. These trends are clearly worrisome. As was pointed out above, the quality of country-level governance affects corporate governance and, thus, firm value. Consequently, some emerging market valuations could be at risk of downward readjustment should governance weaken further. 6 Redefining EM: Governance Regimes Are the Key Distinction, August 12, 2015 9
Michael Geraghty is the Global Markets Strategist for Cornerstone Capital Group. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi. michael.geraghty@cornerstonecapinc.com 10
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