Stock markets in developing countries (lll): “invisible” issues

Every market has issues that are often well understood by local investors but not to foreigners.  China found this out a few years ago when a government-related company bid for Unocal, a US oil and gas company whose Pacific Basin reserves it found attractive.  The same for Dubai, when it bought a UK company that held US port operations.  In both cases, Washington vetoed the transactions.

The US isn’t alone in this practice.  Foreigners will find it hard to buy companies in Continental Europe–even EU members may be unable to make acquisitions in neighboring countries.   And Japan has enacted laws over the past ten years that make foreign takeovers all but impossible–as if the informal barriers already in place weren’t enough.

Stock markets in developing countries have these issues, too–but they also have others that are orders of magnitude greater.  They include:

are company financial statement trustworthy? This is a bigger issue than it might seem, particularly for mid-sized growth companies but often for the market as a whole, as well.

–the first time I went to country W, I met a friend from graduate school who was working as an equity analyst for a large multi-national investment management company.  He was also, it turned out, the son of a powerful local political figure.  His job?  to play golf with company chief financial officers so he could find out what was really going on at publicly traded companies–as opposed to what was in the financial statements.

–at my first international job, my boss told me of a recent trip to country X.  At the end of an interview, the chairman of one company asked if she wanted to see the detailed financial statements of the firm.  When she said yes, he reached over his shoulder, retrieved a binder from a shelf and gave it to her.  As she perused the figures, an aide whispered in the chairman’s ears.  He took the binder from my boss and replaced it with another binder, containing completely different figures.

–an investment banking friend about a firm in country Y that approached his firm during the early Nineties emerging markets boom about taking it public.  The financials were horrible.  The banking firm pointed out the problems–no growth, excessive debt…, apologized and said it couldn’t arrange an IPO.  Several weeks later, the company returned with completely different financials–and, of course, being an investment bank, my friend’s firm took the company public soon afterward.

–I once visited a mid-cap apparel company in country Z that told me a glowing growth story filled with sharply increasing sales and lots of operating leverage working in its favor.  At the conclusion, management said its annual accounts had just been published a day or two before and offered me a set.  As I flipped through the documents, the figures showed much slower revenue growth and no operating leverage.  I pointed this out.  The chief financial officer replied that the rapid growth was taking place in the underground economy and was completely off the books.  At least I still had my wallet when I left.

public/private company conflict. In my experience, this is an issue, particularly in property and construction, in any stock market.  It should be understood that strangers won’t make as much money as family members will from a given project.  But local investors will have enough history to distinguish between families that treat minority shareholders in a publicly traded company well, and those who don’t.  That experience usually accounts for apparently inexplicable price earnings multiple differences between firms.

In developing countries, the issues can quantum leaps bigger.  For instance:

—back to my friend in country W.  The investment firm he worked for bought a large position in a maker of consumer electronics during a robust economic upturn.  Yet the stock went down almost every day.  It turns out the publicly traded company was selling its output at just over cost to a non-public distribution company owned by the manufacturing company’s chairman.  That’s where all the profits were going.

–a fellow analyst went to see a Hong Kong shipping company during an economic downturn.  The chairman assured him that all the company’s ships were under long-term charter and would not be hurt by the slump.  That’s funny, my friend replied, that’s not what it says in the annual report.  Oh, you mean the public company, was the explanation.  It turns out the controlling family had two shipping companies, one public, one private.  The most lucrative contracts went to the private company.  The public company got the riskier and less profitable ones.  Both firms later went bankrupt.

— this kind of conflict can extend into the political sphere.  In some countries–ones without exception to avoid, in my view–the difference between success and failure may be having a political party or a relative of a dominant political figure on the payroll or on the share register.  The politically oriented firms are relatively easy to detect.  But this activity also means that honest, hard-working managements in good businesses may not succeed and may be avoided in the stock market–because everyone knows they have no political clout.

national champions.  This is not so much an “invisible” issue as it is one of different cultural and social aims.  The bottom line is that a given market may have publicly traded companies that are not intended to make money but instead to “take one for the team” on a perpetual basis.  For any country following the Japanese development model, for example, banks are more like not-for-profit companies.   Their main job is to channel national savings to export-oriented firms through cut-rate loans.  A mining company may have the goal of providing employment for a country’s citizens and will therefore operate at a loss when profit-minded firms would reduce production.  An oil and gas exploration firm may enter into loss-making development deals that give it control over energy output so that it can deliver energy to the home country in time of need.  Or it may sell output at very low prices to local refiners to provide a price subsidy for consumers.

Local institutions may feel compelled to own the stocks of such companies and take part in new capital raising, but these issues are probably not ones a foreigner will be rewarded for owning.

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