OREANDA-NEWS. July 26, 2013. Sberbank Investment Research, the research department of Sberbank CIB, announces the release of its new Corporate Governance research report.

The report, entitled “Russian Corporate Governance – Embracing the Opportunity,” provides a fresh and comprehensive overview of Russian corporate governance. The report also looks at the Russian government’s progress in turning Moscow into a major financial center and analyzes its new draft corporate governance code.

Poor corporate governance is often cited by fund managers as the principal reason why Russia’s valuation gap versus emerging market and developed market peers exists and why it has widened over the past decade. A key outcome from the analysis is a watch list of stocks that we believe are set to materially improve their corporate governance, which should be rewarded by strong outperformance over the medium term.

In the report we take an in-depth look at corporate governance in Russia by doing the following:

Categorizing 160 Russian corporate governance events over the past decade for Russia’s largest listed equities into 12 quantifiable corporate governance factors and then analyzing these against each company and sector’s subsequent share price performance across various time periods.

Normalizing each stock’s share price performance post-corporate governance event versus the market/sector to help eliminate bias and noise. We then quantify the relative importance of each of the corporate governance factors to establish a ranking of factors that matter most for equity holders.

Using this fresh analysis and the views of our sector analysts to identify a watch list of Russian stocks that may be at an inflection point in terms of adopting more progressive corporate governance policies. We quantify what the potential upside might be.

Analyzing progress made in the Russian government’s cooperation with the OECD (and others) to update the 2004 voluntary Code on Corporate Governance and assess the merits of a potential plan by Moscow Exchange to launch a Novy Rynok (“New Market”) Index with corporate inclusion largely based on adherence to best practice corporate governance principles.

Benchmarking Russian corporate law, corruption and corporate governance versus other GEMs including China, Brazil, India and South Africa.

Main conclusions

Despite attractive valuations, the perception (and reality) of corporate governance risk tops most investor concerns when it comes to investing in Russian equities. Simply put, attractive valuations and superior growth characteristics of specific equities matter less when there is no trust and where fear of the unpredictable overshadows rational decision making.

That said, we do not believe that the consensus view is a fair general assessment. It is a case of the exceptions grabbing the headlines, and unfortunately many of those headlines come from the large, state-controlled energy and industrial corporations. Our research suggests that companies in the more secular-growth consumer, media, transport and financial sectors, for example, have either adopted good corporate governance standards or are at least on par with their EM counterparts.

The top four corporate governance factors ranked in terms of the strongest impact on sector and market relative share price performance are (in order of importance):

Undermining minority shareholders.
The threat of nationalization.
Major changes in financial transparency.
Use of cash and/or dividend policy.

The key corporate governance factor affecting price performance is treatment of minority shareholders. Abuse minority investors and you get de-rated by an average (across our sample) of 24% in a month, 40% in six months and 50% in 12 months. Treat them right and corporates are re-rated (albeit to a lesser extent). Somewhat surprisingly, we found that other corporate governance factors often thought important by investors had little impact on share price performance, such as changes in the BoD and management, news on privatization, and the adoption of IFRS accounts.

The reason for poor Russian corporate governance at the company level is baked into the ownership structure of the Russian market. Simply put, the state or oligarchs control more than half of the equity market and thus directly influence the use of cash flows, while the overall equity market free float is disproportionately owned by foreigners that only exert limited influence. Our analysis of the underperformance of state-controlled companies makes this point relatively clearly.

Poor corporate governance acts as a “tax” on Russia’s most innovative companies when they try to raise capital. For example, the cost of Pharmstandard’s actions is met by taxpayers through lower revenues for privatizations.

There are three key ways to improve corporate governance in Russia, all of which can be shaped and influenced directly by the state:

Increased free float.
Exemplary behavior by state-controlled companies.
Ruthless enforcement of the word and spirit of the law to stop the abuse of minority shareholders.

Russian equities that begin to deliver positive corporate governance after treating minority shareholders poorly are rewarded by circa 45% relative outperformance from the inflection point over the following 12 months.

Benchmarked against other emerging markets, we find that Russian corporate law is relatively protective of shareholder (and minority shareholder) interests and that overall levels of corruption are no worse in Russia than the average in China, India, Brazil, Turkey and South Africa, as reviewed in this report. However, a key area where Russia clearly needs to improve is in the policing and enforcement of existing regulation and statute. The independence and consistency of Russia’s legal system is also an area where Russia seems to fall short – a thorny problem indeed. Macro factors aside, outperformance of the wider Russian equity market is therefore critically dependent on the attitude of the state in such matters and its attitude to the corporate governance principles at the heart of most state-controlled enterprises.

This year’s Russia business headlines have included several negative corporate governance events, such as Rosneft’s dismissal of TNK-BP minority shareholder claims, the lack of ownership clarity when Surgutneftegaz finally produced IFRS accounts, and the recent sharp decline in Pharmstandard’s share price triggered by concerns about potential value-destruction related to a carve-out. That said, many examples of strong and positive corporate governance changes do exist on the Russian equity market, and we are cautiously optimistic about Moscow Exchange’s tentative plan to develop the Novy Rynok, which seeks to establish a premium stock market listing for corporates meeting minimum corporate governance standards, and are encouraged by the work being conducted by the state to upgrade its 2004 voluntary Code of Corporate Governance.

We recommend a medium-term investment strategy to buy stocks, offering three simultaneous criteria:

Undemanding cash-based valuation multiples (especially deep sub-sector discounts).

Perception of recent or historic poor corporate governance.

Senior management that appears committed to adopting more progressive corporate governance policies.

Many of the corporate governance improvements we discuss in this note, we argue, would lead to lower business and financial risk (specifically a lower cost of capital), improved valuations, enhanced cross-border trade and financial flows that would benefit Russian issuers and investors alike.