Key success factor for emerging markets investors: the KYO approach

As they do in developed markets, investors looking for promising equity investments in emerging economies typically begin their search by looking at a company’s P&L (profit and loss) and other financial documents. Our experience has shown that it’s the wrong place to start. In fact, it all begins with the owners.

Evaluating the ownership of a company means ensuring that the enterprise is driven by reliable, trustworthy stewards, with enduring vision and commitment. We call this “Know Your Owner,” or KYO.

Why is KYO so important? For one thing, good owners—majority shareholders or company founders—hold the key to positive environmental, social, and governance (ESG) performance. The reason: responsible owners have an outsized impact on good governance. And when the “G” is solid, then the “S” and “E” typically follow.

What’s more, research shows that companies with good owners have better financial outcomes. Research into the performance of family-owned businesses during the COVID-19 pandemic showed that such companies, which generally take a longer-term view in their decision-making, exhibited greater resilience than their nonfamily-owned counterparts through the pandemic. They also continued a pattern of generating stronger top-line growth and more profitability.

For investors, the KYO approach also requires that we act not just as financial backers, but as responsible owners, ourselves. That means assuming a long-range perspective and identifying visionary founders with the commitment needed to leverage key trends such as the growing global middle class, digitalisation, and efforts to achieve the Sustainable Development Goals.

Shareholders first

At East Capital, we learned this lesson through our early work in Russia and Eastern Europe after the fall of the Berlin Wall. In the free-for-all of that time, as new companies started up and old ones tried to navigate an emerging economic paradigm, evaluating businesses was a Herculean task. Existing accounting systems were largely meaningless and often impenetrable. Under the old system, bartering of sugar and other coveted supplies had been a common method for transactions and was still in place for some companies in our investment universe.

The only solution for us was to adopt a highly hands-on approach - digging deep into not just financial records, but also the track record and reliability of company owners. As soon as we opened an annual report, the page we always turned to first was the one with the list of shareholders. Only after that would we look over the financial statements. In other words, without realising it, we were making decisions largely influenced by KYO and the “G” of each enterprise.

Tell-tale signs of good ownership

The hallmarks of excellence in ownership are all about collaboration, independence, and responsibility. For example, there’s the matter of how much is owned. When the largest shareholder owns no more than 25-30% of a company, it spurs cooperation and collaboration, because the individual has to rely on other shareholders to reach a majority decision. Other key ingredients: a proven track record of responsible ownership, and a board with truly independent directors.

Questions about the degree of independence – and the ability to represent the interests of minority shareholders – should be raised where any director has been an employee of the company within the last three years, has been a non-executive director of the firm for 10 years or more, or recently has had significant financial dealings with the company. Incentives also must be well aligned between owners and shareholders. This should be reflected through the compensation structure of both the board and management, something that is actually quite rare to find even in developed markets.

KYO kick-starter

So, how do you put KYO into practice? A good place to start is by investigating companies with strong founders at the helm, as well as the largest shareholders: They tell you a lot about how the company is run. A bedrock of reputable shareholders will be critical should investors need to team up when engaging with the company. Keep in mind that ownership in emerging and frontier markets is less institutionalized than in developed markets. As a result, it’s more personal than the “ownerless” capitalism seen especially in the US. This is why, investors need to be on the ground - meaning, you have to meet the owners, virtually if not physically. While some shareholders may be reluctant to engage, those who are in it for the long haul will most likely be glad to establish a dialogue.

Next comes meeting the management team, and posing the same questions you ask owners, to see if there are discrepancies and to understand how pervasive the corporate culture is.

Of course, it’s also important to understand what characterises bad owners. A few common traits should raise alarm bells: mistreating minority shareholders, engaging in unfavorable related-party transactions, not acting in an environmentally and socially responsible way, and at the worst, breaking laws.

To be sure, KYO-oriented investors should be braced for multiple challenges, from encountering corruption and fraud, to directors who are independent from a strong founder in name only. Companies in emerging and frontier markets tend to be covered by fewer analysts than in developed markets, and some aren’t followed at all. Also, due to less-rigorous regulatory disclosure requirements, information might not be reliable - or even available. Meanwhile state-owned companies, though risky, often can’t be avoided, and their quality levels differ substantially from one to another and from country to country. Not all governments are good owners. 

The issue of good ownership is a soft area that is difficult to quantify. As a result, ESG data providers and many fund managers, including less dedicated ones and those that are quant-driven, tend not to include such criteria in their evaluations. KYO is an approach that, when done thoroughly, can take time and commitment. But for anyone serious about finding risk-adjusted value in emerging and frontier markets, it should be the foundation of their investment strategy.

Updated 2024-06-25
Written 2021-09-13