EM investors shun state-controlled stocks

October 31, 2013 9:39 am

EM investors shun state-controlled stocks

By Robin Wigglesworth

Asset managers always fear the heavy hand of the state tampering with their investments. But rarely have they shunned government-controlled companies in thedeveloping world quite so fervently. In contrast, money has largely continued to gush into companies that are geared towards consumer spending in emerging markets – whether staples like rice crackers and beer, or more discretionary areas such as television sets and cars.Some analysts and money managers feel the valuation divergence between unloved state-owned enterprises(SOEs) and consumer stock darlings is now too great. Indeed, Ajay Kapur, an equity strategist at Bank of America Merrill Lynch, argues that it represents a “massive concentration risk” in the portfolios of many investors.

These SOEs – for the most part national champions likePetroChina, Sberbank or Petrobras – now trade at close to a 50 per cent discount to their private sector peers, according to BAML.

There is “clearly a massive state capitalism discount, a prejudice directly connected to state ownership. The market just does not trust the state to do the right thing,” Mr Kapur said in a research note.

There are good reasons for why a discount should exist. Although SOEs may benefit from government-subsidised or guaranteed loans, tax benefits and favourable state contracts, shareholder returns are not the priority.

“We’ve seen many times before that profits can get swallowed by a big capex programme,” says Emily Whiting, a client portfolio manager at JPMorgan Asset Management. “A lot of these companies simply aren’t run for minority investors.”

Chinese and Russian banks and energy companies are classic examples, but even Brazil often instructs companies to support government policy. Petrobras, for example,unofficially provides a fuel subsidy domestically to help control inflation – costing it billions of dollars in profit.

As a result, shares in companies such as Petrobras, Bank of China and Gazprom trade below the balance sheet value of their assets, the so-called book value. Gazprom trades at just over three times its earnings, compared with 11 times for the MSCI Emerging Markets gauge as a whole.

Investors tend to be seduced by naive stories, like the EM consumer narrative. Yes, these populations will consume more over time, but that may already be factored into stock prices

– Peter Marber, head of emerging markets investments at Loomis Sayles

Meanwhile, groups that garner profits from selling consumer goods are trading at punchy valuations. Want Want China, a maker of rice crackers and other snacks, is worth 10 times its book value, and Nigerian Breweriestrades at almost 11 times its book value.

Some analysts feel that the overall, aggregate level of the SOE discount is now overdone, and fret that consumer stocks are looking bubbly.

The 20 cheapest stocks of the 100 largest EM companies have only been this cheap compared with the overall gauge three times in history – at the depths of the crises of 1998, 2002 and 2008. Meanwhile, the most expensive 20 stocks – largely consumer goods companies – are in the 97th percentile of historical observations.

“Investors are exceptionally underweight in the unpopular SOEs and egregiously overweight ‘growth-oriented’ consumer/internet and telecoms names,” says Mr Kapur.

Counter to widespread perception, research shows that SOEs tend to do better over time. Morgan Stanley’s Jonathan Garner last year crunched historical performance data and found that state-controlled groups have outperformed the benchmark by a wide margin over the past decade.

There are various explanations for this surprising outperformance. In addition to obvious reasons such as government largesse, lower borrowing costs from state links and sectoral skews, some fund managers point out that private companies in developing countries are often owned by families or oligarchs. Shareholder governance can prove just as tricky in these groups.

Peter Marber, head of emerging markets investments at Loomis Sayles, is no fan of companies where state policy matters more than shareholder returns, but feels that many investors have become overly infatuated with the EM consumption theme in particular.

“Investors tend to be seduced by naive stories, like the EM consumer narrative. Yes, these populations will consume more over time, but that may already be factored into stock prices. Indeed, some consumer plays are clearly overvalued,” he says.

On the other hand, slowing growth and more testing financial conditions could encourage another bout of reforms and privatisation in the developing world, acting as a catalyst for improved performance for SOEs.

This may appear an overly optimistic scenario, but it is one that Mr Kapur believes has already begun to play out. “The time for action is near – the markets and populations will be more vocal in demanding change,” he says.