A savvy investor’s guide to corruption

MoneyWeek magazine cover illustrationIf you know what to look out for, investing in corrupt markets can actually boost your returns, says Jonathan Compton.

To a greater or lesser extent, corruption, in all its various forms, is a problem in most countries. As corruption is largely about the abuse of power, control and money, it can also have a serious impact on the investment case for a market or company. Yet it’s a subject that the investment industry has often preferred to gloss over.

Analysts are loath to highlight that many of the stocks they cover are run by a bunch of bandits. (My own favourite example, from the 1980s, was Ma Sik-yu – or ‘White Powder Ma’ – who controlled several listed Hong Kong and Taiwanese companies, and eventually died in exile in Taiwan, wanted on heroin-trafficking charges.)

Strategists and economists (who don’t directly cover individual companies) occasionally pay lip service to the topic, but can usually be relied upon to brush monumental dishonesty at the national and corporate level under the carpet.

Pointing the finger at countries and companies wins few friends and even less new business, and also runs the perennial risk of litigation. As a result, much market analysis is seriously flawed, especially in developing markets.

Indeed, up to the late 1980s, little if any thought at all was given to the impact of corruption on economic activity or stock-market valuations. In part, this was because finance was a cartel – in itself a form of corruption – with fixed fees, significant barriers to entry and much business being carried out on a ‘nod and a wink’ basis.

The juiciest financial morsels, such as ‘hot’ new issues, were openly handed out to favoured friends. This was simply how stock exchanges in London and most other parts of the world functioned.

However, a series of high-profile scandals and large financial losses – notably the Savings and Loan crisis in America – saw governments forced to pick up the bills for bailing out the system, as well as taking the flack from raging electorates. This persuaded them that the cost of such grey practices was too high.

Since then, more policy wonks – from the International Monetary Fund and the World Bank, to myriad state and international non-governmental organisations (NGOs) – have been employed trying to measure, weigh, and reduce global corruption levels.

But how do you measure corruption?

The word itself is very elastic. Corruption encompasses everything from distorting government policies against the national interest, to minor officials allocating the public’s access to phones or electricity; from leaders enriching themselves at the expense of the state, to the public’s right to use services such as the best schools and hospitals (gaming postcodes for these has become an almost acceptable form of mild corruption in the UK).

Many academic papers have been published on how corruption might affect growth or political stability.

As is so often the case in academia, debates can be visceral. The greatest criticism is levelled at counter-intuitive studies that suggest that on occasion, efficient corruption can make development happen more quickly than obeying complex regulations.

This perhaps explains why the railway on the French side of the Channel Tunnel was completed over a decade before Britain’s shorter section.

Does corruption matter?

Moral scruples aside, the issue for investors is this: does corruption have a significant impact on stock-market returns? Given that state corruption takes place in the shadows, data collection can never be scientific, so no one can know for sure.

Intuitively, dishonest companies and regimes are less efficient and have a shorter shelf-life. Yet the more corrupt a given government is generally thought to be, the more its data often appears to show the opposite.

For example, the league table of banks being prosecuted or fined for misdeeds not only reads like a Who’s Who of the industry, but shows the most corrupt systems to be in America and Britain. By this measure, the paragons of banking virtue abound in China, India and Thailand. Clearly, this is a flawed starting point.

The good news is that there are sources of reasonable data. Much is available from Transparency International, a not-for-profit organisation established in 1995 to monitor many corruption measures.

Every year it produces global tables and summaries that pass the common-sense sniff test. In 2013 it found the five least corrupt countries were Denmark, Finland, New Zealand, Sweden and Singapore.

At the bottom were Libya, Sudan, Afghanistan, North Korea and Somalia. While there are obvious quibbles – such as Cyprus being more virtuous than Portugal, or Uruguay cleaner than France – the methodology is strong enough.

The World Bank too produces tables (while euphemistically dancing around the patent dishonesty of many regimes). It ranks nations by the ease of doing business, using factors ranging from investment protection and enforceability of contracts, to the ease of simply registering a company or getting electricity.

Not surprisingly, these tables largely tie in with Transparency’s tables, albeit with some bizarre anomalies, such as South Korea and Georgia ranking well ahead of the UK, Canada and Australia. So an investor can achieve a reasonable handle on which countries, and therefore capital markets, are less mucky.

This is where other studies then add value. Papers from Stanford Business School show that market valuations have been affected by widespread dishonesty over the long term. Why? Because foreign direct investment becomes hard to come by, asset values are suppressed and, importantly, the cost of credit for companies rises significantly.

Ten-year data shows that in highly corrupt countries the average company’s price-to-book value ratio was 1.88 times. That compares to 2.19 times for moderately dishonest countries, and 2.4 times for the ‘angels’. In short, investors will pay more to invest in a cleaner environment.

Soft issues also matter: in high corruption countries, protection for minority shareholders – especially foreigners – varied from weak to non-existent. And family controlled firms – which dominate many emerging markets – generally produced lower shareholder returns, often because they were treated as family piggy banks.

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Muck means there’s less brass

Demonstrating that corruption affects long-term value is hardly ground-breaking stuff. But measuring corruption becomes very valuable at turning points, ie, at times when a once-corrupt country starts to clean up its act. This becomes particularly clear when you use inflation-adjusted, cyclical price/earnings ratios (better known as Cape).

These were popularised by the Nobel Prize-winning economist Robert Shiller (hence the other popular name for the ratio, the Shiller p/e). To find the Cape on a given market, you take the current index level, divide by ten years’ average earnings and adjust for inflation.

This allows you to see quite clearly whether or not a given market is trading at a historical extreme – cheap or expensive. It also allows you to compare markets.

For example, at the start of 2012, Cape valuations for the ‘peripheral’ eurozone countries – the likes of Portugal, Italy and Spain – were at all-time lows. Over the next two years, their indices soared like rockets.

Similarly, at the start of 2013 many emerging markets had record-high Cape valuations. Since then they have produced dire returns.

So, why is this relevant to the question of corruption? Take an example from recent history. The 1997 to 1999 implosion in emerging markets began in Asia and rapidly spread across other continents, ending in the collapse of the Russian economy and government (as well as that of Long-Term Capital Management – one of the earlier too-big-to-fail hedge funds in which many central banks had invested heavily).

As with all collapses, one underlying cause was too much debt, exacerbated by currencies being pegged to the US dollar at the wrong exchange rates, which created serious distortions. But in addition, as markets imploded investors were amazed (unpleasantly so) by the shoddiness of accounts, corporate governance and legal protections.

This boosted anti-corruption campaigns. By the start of the 21st century many countries were cleaning up their acts. Partly as a result, they saw spectacular improvements in their valuations.

In 2001, Cape for the Philippines was just over ten times. By 2007 it had risen to 35. Mexico went from 15 to 41.

Indonesia, which under the Suharto regime had been a byword for graft (with notoriously corrupt judges), rose from nine times to 68. But Thailand took the best-in-class award – rising from ten times to 106.

It’s true that emerging markets generally performed well during this period, and also outperformed developed markets. But nevertheless, there was considerable differentiation in valuations between those regimes that were reforming, and those taking little tangible action. The improvements in Cape in India and Russia, for example, were modest.

Watch out for backsliding

Cross-referring changes in the corruption matrices and Cape can indicate where there is better value, but it can also help to avoid long-term value destruction – those countries where a once-improving level of broad honesty in government has started to reverse.

For example, in the decade to 2007 investors fell in love with China for the usual wrong reason – they confused high growth with superior stock market returns.

(Sadly, this approach remains common – most stock market reports start by discussing GDP growth and conclude that the market will move in parallel. At the very best, such correlations are ephemeral.)

Yet, during the earlier phase of China’s boom there appeared to be significant efforts to reduce the spectacular level of corruption within the Communist Party and local governments.

For a while, its Cape multiple soared. Then, after the crash of 2008, China embarked on a level of quantitative easing that – relative to GDP – put the US into the shade. But at the same time, reform efforts ceased. Ever since, China’s Cape has been subsiding.

In South Korea, the tables show perennially high corruption. In 2013, it ranked second in Asia for corporate corruption and lenient punishment of offenders, and was also deemed the most corrupt developed country in Asia.

The chaebols (giant conglomerates) that dominate the stock market have never seriously pretended to be cleaning up their act. Hence in the last decade, South Korea’s Cape has fallen from 24 to 14 times.

This market always looks cheap, but for good reason. Returns to investors, the costof borrowing and corporate profits, have all suffered accordingly. It’s a case study of why corruption doesn’t pay long term.

Where are the opportunities today?

Today, if you overlay Cape ratios on the World Bank and Transparency International tables, it reveals some worrying overpricing. The current Cape for the Philippines is 25, while Malaysia and South Africa are both on more than 20.

In each case, these are well above the long-term averages, even as improvements in governance, productivity and reform seem to be stalling. In these and other expensive-looking markets, forget buying the ‘cheap’ stocks – all they will produce is smaller losses.

Elsewhere, many valuations as measured by Cape are also high – particularly in America where, since February 2009, Capehas moved from 11.4 to 23.2 times. Yet Cape is only one valuation measure. There are other, more important forces in play.

In a world of central banks desperate to hold down interest rates for as long as possible, valuations should be, and are likely to remain, ‘extended’.

Even so, there are standouts. Surprisingly, among the lowest Cape valuations is the UK, at 12.9 versus a 15-year average of 17.3.

In emerging markets, we may be nearing a particularly interesting inflection point in Brazil. The Bovespa trades on a Cape of 9.9, from 28 just 18 months ago, even as corruption levels appear to be steadily diminishing.

And while Mexico – on a Cape of 21 – looks expensive relative to manyof the rightly beaten-up emerging markets, not only is this level well below the long-term average, but the country has made steady progress in gradually shutting down drug cartels, tackling police corruption and dismantling excessive bureaucracy.

The combination of data on dishonesty and malfeasance coupled with a long-term Cape overlay shows that there’s good money to be made from investing in corrupt stock markets, once there is the will and sufficient action to curb their worst excesses. I’ve suggested some promising options below.

The six stocks to buy now

As a firm believer in ‘mean reversion’, I see a growing probability that increasingly irrational President Cristina Fernández de Kirchner and her kleptocrat government will be ousted for incompetence. So, with a global corruption ranking of 102, and the world’s third-lowest Cape, Argentina is a racy lose all/win all play.

It would be great to get exposure via an exchange-traded fund (ETF), but they are all too small or illiquid to recommend. Instead, use local large companies listed in New York in ADR (American Depositary Receipts) form.

One is Arcos Dorados (NYSE: ARCO), the McDonald’s franchisee with a market capitalisation of $2bn, which has halved in the last five years.

The other is MercadoLibre (Nasdaq: MELI), which by contrast has more than doubled due to its rapidly growing ecommerce business (its market capitalisation is $3.75bn).

To buy this one requires extra courage, given its large exposure to Latin America’s other looney tunes government – Venezuela.

In Brazil, the choices are broader and the risks fewer. The largest ETF, with assets of over $4bn, is the iShares MSCI Brazil Capped ETF (NYSE: EWZ).

As for individual stocks, it’s often forgotten that Brazil has a large industrial base. The aerospace and aeroplane maker Embraer (NYSE: ERJ) is one of the two largest players in the mid-range carrier market, slugging it out with various degrees of success against Canada’s Bombardier.

Each claims an edge over the other in terms of fuel efficiency, service costs and safety, but this segment of aviation is set to grow much faster than long haul, as growing wealth results in more demand for local short-haul holidays and trips for a few days, now so common in developed countries. Embraer’s performance since 2011 has been dull, with only a fractional share price rise.

A broad consumer play across a growing number of Latin American countries is Cinemark Holdings (NYSE: CNK), which owns more than 300 film theatres in America, but has rapidly expanded into Latin America, where it now manages nearly 150 large theatres and where growth is faster.

Over the last five years, its share price has risen from $11 to nearly $30, but this has been largely a reflection of the rise in its earnings.

In Europe, the re-rating of the peripheral nations (some of which are more sclerotic than corrupt) in recent years now looks almost ripe. But Portugal’s dominant oil and gas refiner and fuel provider GALP Energia (Lisbon: GALP), which I’ve personally owned for the last two years, looks cheap and seems well run.

Its electricity and gas generation and distribution businesses are steady earners, while the exploration portfolio looks undervalued. At $9bn total value, the risks are more than reasonable.

• Jonathan Compton was until recently MD at Bedlam Asset Management and has spent 30 years in fund management, stockbroking and corporate finance.

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