Emerging markets provide many potential investment opportunities, but corporate governance shortfalls can present challenges. Over the years, some countries have moved faster than others to plug their governance gaps. In the first of this two-part series, Franklin Templeton Emerging Markets Equity’s Chetan Sehgal and Andrew Ness outline what corporate governance is and how emerging markets are making improvements in this area.

Corporate governance is a term that is easier to grasp than define. It is a sprawling subject, and its definition can vary from one investor to another. That said, academic and industry research tends to view corporate governance at the country and company levels.1

  • Country: Laws, regulations and policies that shape the investment environment typically take center stage. Investors look to the quality of a market’s public institutions, reflected in the strength of its property rights, disclosure standards and other features, to determine how much they can trust the market with their capital. These features also form the institutional framework in which companies operate.
  • Company: Here, checks and balances between a company’s board, management and shareholders are key. We believe internal systems that help the board to effectively monitor management, incentivize managers to act in the best interests of all shareholders, or enable shareholders to hold the board to account should contribute to sound governance.

We think, at its core, corporate governance determines how well companies are able to operate in the longer-term interests of all shareholders. One study offers this definition: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.”2

The Search for Alpha

What makes good corporate governance vital? To start, it is integral to a company’s sustainability. A healthy system of controls, incentives and values, reflected in features such as a majority-independent board, well-designed executive remuneration scheme and sensible capital allocation framework, should enforce discipline on management to steer the business for the long haul.

Also striking is the impact governance often has on stock valuations. The market has typically discounted companies with poor conduct or policies deemed to shortchange investors. Governance improvements give these companies a chance to achieve re-rating.

As a whole, studies have largely found a correlation between better governance and increased access to financing, lower cost of capital, stronger operational performance and higher valuations for companies.3

But to be clear, corporate governance is just one factor out of many that can affect a company’s prospects and share price. We think investors should assess a firm’s governance alongside traditional financial measures to form a comprehensive view of the potential investment returns and risks.