The level corruption in most emerging or frontier markets is not a secret anymore. Mark Mobius, and many other emerging markets investors, consider corruption a cost of doing business. In this article, from an investor point of view, we are going to treat corruption the same as Mark Mobius.
Risk VS Reward
One fundamental reason of investing in frontier markets is the potential of higher returns than in developed markets. If we treat corruption as a cost of doing business, investing into a company that is exposed to corrupt officials, then corruption can be treated as a matter of risk-reward analysis. Can the company you invest in, offer a higher return that will offset the risk of corruption in that country? This is something that you have to analyze and accept.
Good and bad corruption
The argument that corruption can be divided between good and bad have existed for some time. Good corruption is one where the ‘dirty money’ are returned within the economy through spending. Bad corruption is one where money flows out of an economy and is stack in offshore accounts. With this is mind, there is no surprise that most of the high figures involved in Panama Papers have been government officials from emerging markets.
Levels of corruption
Mark Mobius also states that corruption levels varies, not only for each country, but from sector to sector. Usually, more regulated sectors tend to face more corruption.
Sectors as energy, telecommunication, natural resources, infrastructure or heath-care are prone to corruption for one simple reason: due to regulation, they face more government and bureaucratic scrutiny. And what does more scrutiny involves? More approvals from decision makers.
Corruption takes the power of decision making and impartiality of the rule of law and puts it into the rule of people that tend to be personal and susceptible to favoritism. In turn, this favoritism has a strong impact on regulated sectors due to the volume of red tape involved around official decision making.
No reliable indicator
Although institutions as Transparency International offer statistics on corruption levels for countries, is it almost impossible to asses the impact of corruption on investment in frontier markets companies.
Should corruption affect investment decisions
Whether we like it or not, corruption is here to stay… unfortunately! All we can do is acknowledge its existence and try not to encourage it and spread it even more.
We acknowledged that corruption is widely spread, but how does it affect our investment decision?
Although we do not recommend it, we can ignore corruption completely. If there is corruption at a national level, then all economic sectors are affected, so ignoring it, we can focus on companies with strong fundamentals and great corporate governance.
Or we can acknowledge it as a cost of business, and in trying to reduce costs, look for opportunities in sectors where corruption doesn’t have a strong impact on performance. Sectors such as retail, manufacturing or IT services.
How corruption affects investment performance?
Even if there is no reliable indicator of how corruption affects investment, one correlation between corruption and growth proved true over the years: the more corrupt a country is, the less economic growth is registered. But at the same time, some of the fastest growing companies are coming from countries with higher level corruption than in western countries.
The counter intuitive conclusion that can be taken from this post is that, as corruption, the answer is in a gray area.
Corruption is bad, but from an investment point of view, there is no black or white answer concerning it. As some investors focus on growth and others on value, the corruption factor can be distilled as an investment risk. It all depends on your tolerance to this risk.
Like any investment risk, corruption can affect a company both ways, sucking the growth out of it, or propelling it as an economic miracle. It is the investors due diligence to research the level of exposure to corruption of a company.
And as always, try to mitigate as many risks as possible.
All content on DraculaCapital.com is for information purposes only. Do not use this content as investment recommendation. Every type of investment involves the risk off losing investment principal. Frontier Markets presents higher risks than mature markets.