Standard Life Investments

Through the Lens

Is it time to revisit state-owned enterprises?

For years, investors in emerging markets have avoided state-owned enterprises. However, we believe now is a good time to revisit this much-maligned part of the investment world.

  • State-owned enterprises have been shunned by investors - time for a re-think?
  • India's banking sector has turned the corner after a series of painful writedowns
  • How Korea is taking on the all-powerful chaebols

Is it time to revisit state-owned enterprises in global emerging markets?

While there are several good reasons to invest in a global emerging markets (GEM) fund, one compelling case regards state-owned enterprises (SOEs). Emerging markets in particular contain a relatively high number of SOEs. Historically, however, these entities have underperformed privately owned companies. Corruption scandals are an all-too familiar occurrence. Many investors, as a result, are reluctant to invest in SOEs. We believe this is a mistake. Sweeping reforms and market liberalisation are finally injecting life into a number of SOEs – creating numerous opportunities for active stock pickers.

A right state

SOEs account for 29% of GEM market cap in aggregate, and have a particularly strong presence in China, the Middle East and Eastern Europe/Russia, where they account for up to 86% of the market cap.1 This is radically different to the developed markets, where a far higher proportion of the market is made up of privately owned companies.

The main problem with SOEs is that government interference and mixed motives often conflict with the aim of generating profit for shareholders. SOEs have also proven to be poor allocators of capital and typically have much lower return-on-equity. They tend to be inefficiently run, with heavy-handed bureaucracy and wasteful cost structures.

Turning the corner

But that's not to say all SOEs are to be avoided. Thanks to far-reaching reforms, many have cast off their legacy ways and are turning around their operations.

Take India's banking sector, 83% of which is state owned.2 Measures have been put in place to reform this bloated industry, including much-needed changes to the Insolvency and Bankruptcy Code. This forced many lenders to writedown the bad loans that blighted their balance sheets. Although the short-term pain was considerable, many banks have emerged from the procedure in better shape than before.

Fighting corruption

As we highlighted, many SOEs are prone to corruption and operational efficiencies. However, several have installed new management teams to turn around their fortunes. An example is Rushytdro, which owns the vast majority of Russia's hydro assets. After a troubled past, the company's new leadership team is cutting capex and has a new-found focus on efficiencies. These measures should improve cashflows and ultimately result in higher payouts for investors.

Making reforms pay

Politicians are also playing their part. In Korea, recently appointed President Moon Jae-in has pledged to tackle corruption and cronyism. Firmly in his sights are the nation's huge – and powerful – family-owned conglomerates or chaebols. The top four chaebols account for half the stock market's value, including household names such as Samsung and Hyundai. While these institutions have been the primary driving force behind Korea's remarkable economic performance, they have also become associated with the worst practices of SOEs – corruption, cronyism and monopolistic practices.

However, President Moon has vowed to take on these institutions, including measures to improve corporate governance. Many SOEs have also restructured and adopted more shareholder-friendly policies, including higher dividend payouts. Indeed, in 2016, the dividend yield for the Korea Composite Stock Price Index exceeded the central bank's deposit rate for the first time ever.3

In Mexico, far-reaching energy reforms, started in 2013, are also breathing life into the ailing sector. As part of the legislation, the two state-owned energy firms – Petroleos Mexicanos and FCE – were given the freedom to engage with the private sector, tendering exploration and production contracts. And, after years of decline, oil production is set to hit 3.4 million barrels a day, up from 1 million today.4

Final thoughts

There is no doubt that progress has been made overhauling numerous SOEs. Many of them are now well run, with a more shareholder-focused mindset. That is not to say SOEs have entirely thrown off their negative image, rather that there are many interesting opportunities for investors who are willing to look beyond the headlines.

1 Source: MSCI, Data Stream, UBS Estimates based on free float market caps.
2 https://www.brookings.edu/wp-content/uploads/2016/07/2004_banerjee_cole_duflo.pdf
3 http://pulsenews.co.kr/view.php?sc=30800020&year=2016&no=284486
4 https://www.iea.org/newsroom/news/2016/october/mexicos-energy-reform-is-set-to-revitalise-an-ailing-sector-and-boost-the-econom.html