Emerging Markets & State Owned Enterprises

About 43% of world’s market capitalization is found outside of the United States. Said another way, if you were to take every stock in the world and multiply its total available shares outstanding by it’s price, you would find that roughly 43% of that value is outside of the US. You may be surprised by this statistic given how much attention is paid to the US economy and markets, but there is much more to the story.

It’s understandable given most of our business and financial decisions are focused to events happening within the US. However, when it comes to investing, a global perspective is needed. For the purposes of this paper, we are focusing on one area of international markets: Emerging Markets.  

What constitutes a stock or a country be classified as emerging? There is actually no hard data point or metric that countries either have or don’t have. Rather, there are certain characteristics that result in countries being classified as such. Emerging countries are in the process of developing their economies and typically have higher economic growth, lower per capita income, higher risk of economic instability/volatility, etc. Some of the most well known emerging market countries include Brazil, Russia, India, China, and South Africa. While investing in these types of countries have their own inherent risk, they can provide diversification, lower valuations, and the opportunity to participate in higher growth potential.

Within emerging markets, investors are faced with a greater number of companies being owned wholly or partially owned by the government, called state owned enterprises (SOE). It’s worth noting that even the US has several state owned enterprises, yet when it comes to investing globally in stocks, SOE’s tend to be more prevalent within emerging markets. Ownership and management structures of companies can vary, yet the common driving force has been generating shareholder profits and returns. If a company is owned by a government, there can be a conflict of interest for shareholders as governments often have a vast array of priorities other than generating shareholder value. Capital allocators around the world are becoming more cautious in investing in SOE’s due to their governance structures, societal pressures, geopolitical issues, etc. As these factors are weighed, we need to understand just how prevalent SOE’s are when investing in emerging markets. WisdomTree completed a study of 800 emerging market companies and identified approximately 220 companies having more than 20% government ownership.  This represents about $1.4trillion of market capitalization which is about 28% of the original universe’s market capitalization meaning this is no small matter.

The exposure of state owned enterprises is significant, yet we must ask if this has led to any meaningful performance gap. If shareholder value is not the main priority of government owned companies, then one would think that there should be a meaningful difference in the performance and quality of companies. The figures below (source: WisdomTree) compare the performance of Non-SOE vs. SOE companies, and as you can see over the last 13+ years there has been a significant divergence in the returns.

Performance, while important, only tells part of the story. If SOE’s are not being managed efficiently given government priorities, then we should also see differences in the fundamentals or corporate health of these companies. While there are numerous metrics used to evaluate a company’s health, two important metrics used for comparison are: 1) Return on Assets (ROA) 2) Return on Equity (ROE). Return on Assets measures how much income/profit a company earns for every dollar of assets, and the higher the ratio the better. Return on Equity measures how much income/profit a company earns for every average dollar of shareholder equity, essentially evaluating how effective management is with investors’ dollars, and as is the case with ROA, the higher the ratio the better. The figures below (source: WisdomTree) look at these two metrics over time going back to year end 2016 comparing Non-SOE’s vs SOE’s including the broad emerging market index for reference. While there are certainly fluctuations in these metrics over the years, a solid case can be made for the higher quality nature of Non-SOE vs. SOE companies, and has even appeared to widen in recent years.

Finally, it’s worth noting the differences in industries represented within these two groups. Over the last several years we have seen the strength of the consumer and the growth of technology, but when we look at the sector exposures of these SOE’s, we note several differences in the figure below (source: WisdomTree). The involvement of emerging market governments in companies has concentrated toward financials, energy, and materials sectors, collectively making up about 66% of the SOE exposure. Conversely, Non-SOE’s have the greatest exposures to technology and consumer discretionary, which have no doubt seen accelerated growth over the last several years.

Emerging markets still have a place in investment portfolios, yet understanding the implications of state owned enterprises is becoming an increasingly important consideration. While historical performance is just that and isn’t used as any forecast, it’s important to ensure that corporate governance structures and priorities are aligned with investors. Strategies that are able to strip out exposures to these state owned enterprises, while not able to completely eliminate political risk, present an attractive opportunity for emerging market investors.