Better government means a better environment for investors. A brighter future beckons in China, Russia and Vietnam, says John Stepek.
Governance matters. The way that countries and companies are run has a huge impact on investors and potential future returns. For example, it's fair to say that one of the main reasons that people are generally wary of investing in China or Russia is political risk.
In countries where property claims are lax or poorly enforced, the rights of individuals are secondary to the aims of the state, and cronyism is rife, the needs of minority shareholders particularly foreign ones are not going to be paramount, or often even respected. Indeed, analyst David Fuller of Fullermoney often argues that "governance is everything".
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But as with everything in investment, it's not where we are today that's important it's the direction of travel. As Fuller's colleague Eoin Treacy notes in his book Crowd Money, "improving standards of governance are often a motivating factor that encourages investors to support a nascent bull market".
The point is not to look at the situation in a country compared to "other more highly developed or less-developed nations" the key question "is whether the situation is improving and whether it is likely to continue to improve".
Looking at it like that paints a very interesting picture for investors of where the best opportunities might be right now. You could make an argument that the political climate in many Western countries is deteriorating, with policies frequently based more on grabbing headlines and votes (the payday loans debacle, for example), and keeping special interest groups happy, rather than on improving the long-term outlook for the economy.
But many emerging nations while starting from a far lower base than Britain or the US are making real efforts to carve out a brighter long-term future. From making property rights clearer, to encouraging more private investment, and pushing state-owned companies to become more efficient and less corrupt, the investment climate is slowly but surely getting better in these nations.
Below we look at three countries where governance is improving, and the best ways for investors to profit.
China's next capitalist revolution
China's leaders have just laid out what Charles Stanley's Jeremy Batstone-Carr describes as "the most profound overhaul of the Chinese economy in decades", following this month's Third Plenum of the 18th Party Congress (to give it it's full title).
The 1978 Third Plenum under Deng Xiaoping marked China's move towards a more market-oriented economy, and pundits many of them running China funds, oddly enough are hopeful that these changes will be just as significant.
Their desire to look on the bright side is unsurprising. Anyone investing in China in recent years has good reason to hope for better times.
As Fidelity's Anthony Bolton, whose gleaming reputation as a UK fund manager took something of a hammering when he came out of retirement to head east, put it: "The Chinese stock market has been one of the worst-performing world markets over the last three years or so and valuations remain at a substantial discount to global and emerging market peers. At last, with the publication of the reform programme, we could have a catalyst with the potential to reverse this underperformance."
China has underperformed with good reason. The country's export-led business model was trashed by the financial crisis. It's hard to make money from exports when no one is in the mood to buy anything. So from 2008 the focus shifted to infrastructure investment and property speculation.
This business plan amounted to ordering the banks to fund all manner of infrastructure projects offering negligible or negative returns, to keep the economy ticking over. That's not a viable business model either, and it's one reason why we were particularly gloomy about China's prospects during 2011 and 2012.
So why should you be interested in China now? There are two main reasons. Firstly, investors have adjusted their expectations for China. They've gone from rampant bullishness to widespread bearishness over the last year or so. That's left the market and certain sectors in particular looking cheap on many measures.
Secondly, the Third Plenum really does contain some very promising reforms that if implemented should help China in its goal to become a more consumer-led economy.
The big headline grabber was the relaxing of the one-child policy. This isn't all that radical in itself (if you and your partner are both only children, you're already allowed to have two kids), but moving away from this borderline barbaric family planning regime is a potent statement of intent.
China's demographic picture thanks largely to the one-child policy remains atrocious, but it's surprising how rapidly demographic trends can turn around given the right decisions.
There are also reforms to residency permits, and a widening of the social-security safety net, which should encourage more consumption (if a half-decent safety net exists, Chinese consumers won't be so worried about saving).
On the economic side, as Philip Ehrmann of Jupiter China fund says: "The crucial element of the reform plan is that markets will be permitted to play a decisive rather than basic role in resource allocation, a fundamental change in language.This should set the scene for a greater role for private firms and the stock market itself in driving growth."
Most sectors (with fairly unsurprising exceptions, such as defence) will be opened up further to private investment.
State-owned enterprises (SOEs) in particular, says Ehrmann, will be put under more pressure to perform, improving efficiency, and being expected to pay out 30% of their profits as dividends by 2020, which could make investing alongside the state in SOEs a much more attractive prospect.
In all, as a result of these reforms, Deutsche Bank expects China's GDP to grow on average by two extra percentage points a year over the coming decade.
China still has plenty of problems. It's good news that China's leaders have "opted for deep and swift reform", says Diana Choyleva of Lombard Street Research, because it's their best chance of avoiding "a major financial crisis within two or three years' time". Yet China still faces huge challenges.
Freeing up capital controls could easily lead to a huge outflow, and a weakening of the Chinese currency, the yuan renminbi, as Chinese investors "seek real returns and the rule of law". This money may well return if China's reforms continue, but it could be tough in the meantime.
Asia economist Andy Xie, writing in Caixin Online, is even more bearish. He argues that all these reforms mean nothing without more political freedom. Xie's argument is essentially a moral hazard' one.
A long as the government remains so deeply entrenched in the economy, and exerts most of the influence over it, bubbles will go on being inflated over and over again. "The only meaningful reform is major curtailment of government power. That seems distant."
We'd have a lot of sympathy with this argument. But as Scott Sumner of The Money Illusion says, the point still stands that the country is attempting to change for the better.
"China will avoid the middle income trap" (whereby a country gets stuck at a certain level of economic development, and can't advance any further), "because the Chinese government's over-riding objective is to avoid the middle income trap Pay no attention to the current structure of China as China will be totally different in 30 years, just as the current China is totally different from the China of 1983."
As Batstone-Carr puts it, "an admittedly long-term opportunity might be crystallising at last".
Russia squeezes state monopolies
"No one wants Russia to implode, but the optimists have their work cut out." That was the headline over Roger Bootle's Daily Telegraph column this week. And frankly, Bootle makes a pretty convincing case.
Russia's economy dipped into technical recession earlier this year, and overall growth is likely to be just 1%, compared to a decade average of around 5%.
What's the problem? Russia is overly dependent on oil on the one hand. The surge in the oil price enabled public spending, which boosted growth. But now the oil price needs to stay at around $110 a barrel (which seems precarious, at least) just to balance the budget.
It's not an immediate disaster if the oil price drops, because Russia is in a strong financial position, but it's clearly a threat. Meanwhile, "the productivity improvements made possible by the end of communism and the reforms of the early 2000s have been exhausted".
So despite weak growth, unemployment remains low and there's not much spare capacity in the economy which in turn is inflationary, and prevents the central bank from cutting interest rates to stimulate activity.
Russians themselves save a decent amount of money, but they're very reluctant to invest it in the country, preferring to send it overseas to jurisdictions with less corruption and more respect for property rights.
On top of all that, Russia's demographics are ugly too "the population is shrinking by about 0.5% a year".
It's not a pretty picture. So are there any redeeming features? Well, the good thing about economic slowdowns is that they tend to grab the attention of the people in power. Russian president Vladimir Putin is no exception.
In 2014, the prices that state companies such as Gazprom and OAO Russian Railways can charge will be frozen. Price controls aren't an ideal solution to anything, but the point is to force these firms to be more efficient. As Bloomberg notes, Putin will no longer "tolerate surging costs and bloated investment programmes at Russia's largest monopolies".
As Yaroslav Kuzminov, a rector of the Higher School of Economics in Moscow puts it, "The economy is run by a bunch of tightly knit elites managers of different ranks treat state companies as their own feudal estates rather than as assets they should run in the interests of the country".
In trying to get to grips with this, unemployment is likely to rise as state corporations lay people off, but that will free up workers for more productive jobs. And reducing the scope of the state companies in general will leave room for other, more effective companies to come in.
Russia is also putting more pressure on state-owned companies to pay out 25% of their profits in the form of dividends. From next year, they will need official approval to opt out from this rule.
It may not be a transformative step forward. And Russia still has plenty of problems. As Bootle points out, the optimists have their work cut out. But if you look at the stock market, it's hard to see much evidence of a glass half-full mentality among investors in Russia.
According to Goldman Sachs, the Russian Micex index trades on just 4.3 times projected 12-month earnings. That compares to 8.6 for the Shanghai Composite Index, and 10.5 times for the MSCI Emerging Markets index.
In other words, Russia is pricing in an awful lot of misery, and not much by way of improvement in fact, Goldman analysts think investors aren't giving Russia enough credit for "the effects of various reform programs, the drive for greater efficiency" and the potential for the country to start exporting more energy to Asia.
Another Asian reformer
We've been fans of Vietnam's potential for a long time. It is currently bouncing back after a tough few years following the financial crisis. In 2012, economic growth came in at 5.25%, the slowest rate in 13 years, but it is expected to quicken to 5.4% in 2013, and 5.8% next year.
Inflation has fallen to around 6% a year, from as high as 20% in 2011, according to Standard Chartered analysts, enabling the country's central bank to cut interest rates.
The country also remains very attractive to Chinese companies looking to cut costs by offshoring, as the bank reports. Several China-based manufacturers of everything from textiles to chemicals to tyres are considering Vietnam as a factory location.
As well as reasonably decent infrastructure, the country has a large, still relatively cheap, labour force, whereas in China there's a growing labour shortage and "rising labour and operating costs". With China's labour squeeze only likely to continue, this seems a likely source of foreign investment for Vietnam for many years to come.
What's perhaps more interesting from a long-term point of view is that the communist government, under prime minister Nguyen Tan Dung, is revising the country's constitution. A draft posted this month, according to Bloomberg, "indirectly acknowledges the private sector while saying the state will maintain its leading role' in the economy".
Among potential reforms are plans to raise the cap on foreign ownership of companies. For now, foreigners can only hold up to 49% of voting shares. The hope is that will rise to 60%. Given that Templeton fund manager Mark Mobius claims he is already having trouble buying as many Vietnam shares as he'd like, any hike in the allowance could see even more foreign capital pour in.
The six investments to buy into now
The way to play China until fairly recently was via luxury goods manufacturers. That's no longer the case, partly due to reform. As Quartz notes, French drinks group Remy Cointreau saw sales of its "ritzy brand of cognac and a Chinese cadre fave" fall by 11.7% in its first half.
Other Western companies have also found it tricky to make China pay in the last year or so, amid the country's economic slowdown. It's all the more reason to go direct to the source.
There are various China-tracking exchange-traded funds (ETFs). We've steered clear of these in the past due to the dominance of state-owned entreprises (SOEs). But given that the reforms should push these companies to be more profitable and pay more dividends, having exposure to them seems increasingly attractive.
One useful-looking ETF is the Lyxor Hang Seng China Enterprises ETF (LSE: ASIL). This tracks the performance of the H-shares or red chips' mainland Chinese shares listed on the Hong Kong stock exchange. Or if you're looking for the real bargain-basement, detested stuff, Chinese banks despite rallying in recent months look a good option.
As Eoin Treacy points out on Fullermoney.com, Hong Kong-listed banks are among the few companies globally that still offer dividend yields close to or even higher than their price/earnings (p/e) ratios. In other words, they look unusually cheap.
If you believe China is going in the right direction, the banks look a good bet. The US-listed Global X China Financials ETF (NYSE: CHIX) tracks the banking sector, or my colleague David C Stevenson recently tipped the wider-ranging Deutsche DBX MSCI Emerging Markets Financials ETF (LSE: XMEF).
On the Russian market, you can buy oil and gas giant Gazprom (Lon Int.: OGZD) direct on a forward p/e of just three, or you can track the Russian market using the db x-trackers MSCI Russia Capped Index ETF (LSE: XMRC).
As for Vietnam, Lars Henriksson of the Profit Hunter newsletter likes the Aim-listed Vinacapital Vietnam Opportunity Fund (Aim: VOF) as a way to invest in Vietnam. The fund trades at a 20% discount or so to net asset value.
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