In defence of co-investing with the state

May 3, 2012

It’s hard to avoid state-run companies if you are investing in emerging markets — after all they make up a third of the main EM equity index, run by MSCI. But should one be avoiding shares in these firms?

Absolutely yes, says John-Paul Smith at Deutsche Bank. Smith sees state influence as the biggest factor dragging down emerging equity performance in the longer term. They will underperform, he says, not just because governments run companies such as Gazprom or the State Bank of India in their own interests (rather than to benefit shareholders)  but also because of their habit of interfering in the broader economy.  Shares in state-owned companies performed well during the crisis, Smith acknowledges, but attributes emerging markets’ underperformance since mid-2010 to fears over the state’s increasing influence in developing economies. (t

Jonathan Garner at Morgan Stanley has a diametrically opposing view, favouring what he calls “co-investing with the state”.  Garner estimates a basket of 122 MSCI-listed companies that were over 30 percent state-owned outperformed the emerging markets index by 260 percent since 2001 and by 33 percent after the 2008 financial crisis on a weighted average basis. The outperformance persisted even when adjusted for sectors, he says (state-run companies tend to be predominantly in the commodity sector).

Past performance and state support aside, Garner sees two inducements to buy shares in state-run companies. Firstly, they tend to trade relatively cheaply to their private sector peers (almost certainly because of the risks that state involvement is perceived to bring). Morgan Stanley calculates these companies are a fifth cheaper than the broader index, both on a forward price/earnings basis and on a price/book basis.

Secondly, many of these companies now pay decent dividends. Garner’s sample group of companies exhibits a dividend yield of 3.2 percent versus 2.7 percent for the MSCI index. That’s up from 1 percent in 2007 and should rise to 4 percent in 12, Morgan Stanley predicts. 

It also expects a 15 percent upside to the share price for state-run companies.

Of the 95 state-controlled companies Morgan Stanley covers, it suggests an underweight on only 16. It also most of the companies in its model portfolio: Indonesia’s Bank Rakyat, China’s Shenhua, ICBC and CNOOC as well as Russia’s Rosneft and Sberbank.

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