Wednesday, July 5, 2017

Another Reason to Look at Developing Countries - Decreasing Corruption

In my research and investing I stress three things: people, structure, and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below fair value if not outright cheap. This post is about anti-corruption campaigns underway in many developing countries and the counter-intuitive evidence that corrupt countries may have higher returns.  Ultimately, it’s about people. 

There are anti-corruption movements in several countries.  My impression is that their effectiveness has increased in the last several years. China and several in South America seem to be the most active.

Below is a list I’ve compiled over the last several months.  There’s probably a lot more going on that I haven’t come across, so please add additional insight in the comment section below.  

  • Brazil, Latin America and others. Revelations of long-term government corruption has riveted Brazil in the last few years.  Two corporate giants have been in the limelight - Petrobras and Odebrecht.  Corruption linked with these have led to the downfall of one Brazilian president, other politicians and many corporate leaders in Brazil and elsewhere.  Odebrecht’s under-the-table payments allegedly occurred in 12 South American and African countries (see here and here).  (In what looks to be a good example of confusing size with quality, in 2010 Switzerland’s highest ranked business school, IMD, gave Odebrecht its Global Family Business Award. See here).
  • Peru. The Odebrecht scandal led to large scale anti-corruption protests and action. Three former Presidents, eight ministers and other officials were implicated for suspicion of illegal dealing with Brazilian construction companies (see here).
  • El Salvador. Last year, El Salvador’s former President Elias Antonia Saca and six others were arrested after being accused of corruption and money laundering (see here).
  • Romania. In 2016, almost 1,300 officials were put on trial for corruption charges. This included 3 ministers, 17 lawmakers, 16 magistrates and 20 state-owned company officials. In February this year, an estimated 500k Romanians protested against weakening the country’s tough anti-corruption laws. These were Romania's largest protests since the fall of communism in 1989. The country’s ruling coalition wanted to decriminalize abuse by public officials if the sum was less than ~USD50k (see here and here). 
  • Ukraine. Officials arrested more than 20 former tax officials in what has been described as that country’s biggest-ever corruption crackdown (see here).
  • Kazakhstan. Earlier this year ex-National Economy Minister Kuandyk Bishimbayev was arrested for taking bribes.  Several other high-ranking officials were also sacked and arrested on charges of corruption (see here and here).
  • Nigeria. The country elected President Buhari in 2015 on an anti-corruption platform and it’s been reported that USD9.1b has been recovered (see here).  Another report noted that over US$160m was uncovered in just one week including USD9m from a former head of the state-owned oil company (see here).  Part of this appears to be due to Nigeria’s new whistle-blowing policy (see here).  Nigerians complain that not enough is being done, and that details of the recovered funds and people arrested are thin.
  • China. Last and most importantly China has reinvigorated its anti-corruption efforts in a wide-spread and sustained campaign. It’s notable by targeting both incumbent and former national-level leaders that were previously considered untouchable.  This includes a Politburo Standing Committee member as well as former high-ranking military leaders. 
In contrast, just as corruption and transparency seem to be improving in many emerging countries, the world’s largest developed one seems to be backtracking.  In February this year, President Trump signed a resolution to roll back the rule that forces US energy companies to disclose payments to foreign governments (see here). The US President has also not released his tax returns as has been customary and his family appears to be using their connection to the President to further their business interests (see here and here). Additionally, both the President and Wilbur Ross, the US Treasury Secretary, continue to own assets and businesses that could present serious conflicts of interest (see here).

Be Careful What You Wish For
Except for the small corrupt minority garnishing cash for little value-add, the vast majority of us don’t like corruption. However at least one study shows that equity returns are higher in countries that have high levels of corruption.

The authors of the very excellent 2015 Global Investment Returns Yearbook note that, “Realized returns were higher for equity investments in jurisdictions that were more likely to be characterized by corrupt behaviors.”  In their short study, they found that the average returns of countries where corruption was low, “were between 5.3% and 7.7%. In contrast, the markets with poor control of corruption had an average return of 11.0%.” (The corruption ranking used in the study is based on the World Bank’s Control of Corruption Index (source data and cool interactive graphics and charts are here).

In other words, countries that are considered more corrupt had returns that were between 3.3 to 5.7 percentage points per annum higher than those that are considered less corrupt.


An annual 5.7 percentage point difference is huge.  At 5.3% - the low return for non-corrupt countries - an investor doubles their money every 12.6 years.  At 11% - the return of the corrupt ones – an investor doubles their money in a little more than half the time – 6.5 years.  (To be fair the authors go on to note that, “Because the interval we study is short, our results may simply reflect a period when emerging markets outperformed.”  (The study can be found here). 

Look For Change
People are shocked when I tell them about my investments in countries such as Russia, Jamaica, and Egypt.  One of their first comments is that they’d never invest in such countries because the corruption levels are too high.

Flip this argument on its head and a Pollyanna like myself sees an additional reason to invest. Most investors are pricing in the current corrupt environment. But what if the environment improves? Rick perception decreases and more people and institutions should theoretically invest over time. This may push up asset prices.
Two markets that I’ve been following on and off for a long time – Indonesia and Pakistan - fit this narrative.  Both countries’ headline indexes have performed well and corruption - as measured by the same World Bank Index used in the study cited above – has decreased over the last twenty years. (I’ve written about Indonesia in several other blogs  - see herehere and here. I’ve not written about Pakistan but should at some point).
Pakistan has done the best.  Its headline equity index, the KSE100, rose 18x in USD terms between 1998 and today, a CAGR of almost 18%.  Over roughly the same period its rank rose from being in the 16th percentile of most corrupt countries to the 24th (a lower score indicates a higher level of corruption. CAGR stands for compound annual growth rate. More information and formula is here).
Likewise in Indonesia. Over the same period of time Indonesia’s JSX rose by 13x, a CAGR of about 16%. It's corruption rank rose from being in the 10th percentile to merely being in the bottom 40%.
Returns in both markets were higher than the developed US and developing China. Over the same period the US’ S&P500 index increased by 1.2x, for a CAGR of about 4%, and China’s headline Shanghai Composite index grew by 1.7x for a CAGR of about 6%. 
The lower returns for China and the US were accompanied by not very dramatic changes to the World Bank’s Corruption rank.  China’s corruption level increased in the late 2000s, before improving again to about the same level as it was in 1998.  The level in the US has not changed much.
But 1998 was the depth of the Asian fiscal crisis. Asian stocks and currencies were at a low point, so starting there is not really fair. However, even the US’s rapid 2.5x rise in its headline index since the depths of the US/global financial crisis is lower than Pakistan and Indonesia during the same time period (see below for some rough and rounded figures).

World Bank Control of Corruption Score (1998 / 2009 / 2015)
1998 (June) - 2017 (June)
Return* / CAGR
2009 (Mar) – 2017 (Mar)
Return* / CAGR
Pakistan (KSE100)
16 / 14 / 24
18x / 18%
5.4x / 31%
Indonesia (JSX Composite)
10 / 23 / 38
13x / 16%
3.0x / 22%
China (Shanghai Composite)
46 / 35 / 50
1.7 / 6%
0.5x / 6%
China (Shenzhen A-Share)
Same as above
3.8x / 9%
2.0x / 17%
United States (S&P 500)
92 / 86 / 90
1.2x / 4%
2.5x / 20%

People Count
I’m not a fan of corruption. I’d be clueless in trying to pay-off a local policeman to look the other way for a minor driving misdemeanor or in a bid to get preferential treatment at the border. And not looking like or being a local in many of the countries I invest in usually means I’m not asked for ‘donations’.  

A country’s corruption level does not deter me. I never really considered it as virtually everyplace I have researched and invested is considered to have high corruption levels. In fact, after doing the slapdash research for this post, I think that corruption levels could be an interesting metric to track.
I suspect it will be backwards looking.  By the time statistics show a clear trend of decreasing corruption, equity prices will have already factored this in. How can I try to ascertain real changes that will lead to decreasing corruption?
This ultimately leads back to my core research and investment parameter – people.  Specifically, who’s the person or people in charge of tackling corruption and are they up to the task? Is it being broadly supported or an afterthought? Is it a genuine, far-reaching and on-going process that is genuinely backed by those in power, or a public relations stunt to get more votes or placate protesters?
Ultimately, I look for companies run by good people. Good and bad people can be found all over.  The very admirable Soeyadjaya family made bank depositors whole when Indonesia was perhaps at its most corrupt.  Dickheads like Bernie Madoff and Bernie Ebbers can and do exist in counties that are considered clean. 
Ethics matter. People count.

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