Emerging markets offer plenty of opportunities for investors. By opening themselves to international trade, the structure of these markets is dramatically altered. Foreign and local investments flood the economy with the aim of gaining enormous returns. A massive reallocation takes place and demand explodes.
As a result of these disruptions, the number of mergers and acquisitions grows exponentially. Under these circumstances, it becomes of crucial importance to understand the nature of companies in emerging markets. Such companies share many of the following characteristics:
1. Unreliable market measures:
When valuing publicly traded companies, we draw liberally from market-based measures of risk. To illustrate, we use betas, estimated by regressing stock returns against a market index, to estimate costs of equity and corporate bond ratings and interest rates to estimate the cost of debt. In many emerging markets, both these measures can be rendered less useful, if financial markets are not liquid and companies borrow from banks.
2. Currency volatility:
In many emerging markets, the local currency is volatile. This is the case in terms of what it buys of foreign currencies (exchange rates), as well as in its own purchasing power (inflation). In some emerging market economies, the exchange rate for foreign currencies is fixed. This is creating the illusion of stability, but there are significant shifts every time the currency is devalued or revalued. Furthermore, when computing risk free rates, the absence of long-term default free bonds in a currency denies us one of the basic inputs into valuation: the riskfree rate.
3. Country risk:
There is substantial growth in emerging market economies, but this growth is accompanied by significant macro economic risk. Hence, the prospects of an emerging market company will depend as much on how the country in which it operates does as it does on the company’s own decisions. Put another way, even the best run companies in an emerging economy will find themselves hurt badly if that economy collapses, politically or economically.
4. Corporate governance:
Many emerging market companies used to be family-owned businesses and while they might have made the transition to being publicly traded companies, the families retain control through a variety of devices – shares with different voting rights, pyramid holdings and cross holdings across companies. In addition, investors who challenge management at these companies often find themselves stymied by legal restrictions and absence of access to capital. As a consequence, changing the management at an emerging market company is far more difficult than at a developed market company.
5. Discontinuous risk:
The previously mentioned country risk referred to the greater volatility in emerging market economies and the effect that has on companies operating in these economies. In some emerging markets, there is an added layer of risk that can cause sudden and significant changes in a firm’s fortunes. Included here would be the threat of nationalization or terrorism. While the probability of these events may be small, the consequences are so dramatic that we ignore them at our own peril.
6. Information gaps and accounting differences:
It is not unusual for significant and material information about earnings, reinvestment and debt to be withheld in some emerging markets, making it more arduous to value firms in these markets. On top of the information gaps are differences in accounting standards that can make it difficult to compare numbers for emerging market companies with developed market firms.