Insider transactions: ESG indicator or noise?
How do we identify indicators for our Emerging Markets ESG Survey? The suspension in Huishan Dairy shares provides an opportunity to illustrate how we do this. As companies with a top-quartile performance on our survey’s indicators outperformed those in the bottom quartile by 55% over the last ten years, these indicators are important to us.
• We collect ESG indicators, which we use in our investment process
• The Huishan Dairy incident offered an opportunity to review our indicators
• Including insider transactions improves our ESG indicators in emerging markets
What are the conditions leading up to a corporate governance incident? Too few qualified outsiders on a board, one might suggest, which enables unsupervised management decisions. Perhaps, but most closely held companies never experience a corporate governance incident. Was it the fault of the auditors then, who did not pick up on the fraud? Certainly, the quality of many auditors in emerging markets falls short, but in many corporate scandals it is not immediately obvious which audit rules, or even principles, were broken.
Governance blow-ups are, in other words, hard to predict by looking at a limited number of obvious shortcomings. This idea was adopted a long time ago in high-risk industries, such as mining, where too few data-points for rare catastrophic accidents exist to draw statistically significant conclusions. Instead, the industry adopts leading indicators of precursor circumstances that can be measured frequently.
Sometimes the causal relationships with such indicators are not clear at all. In the case of a mine collapse, for example, it may seem a stretch to suggest that staff not wearing seatbelts for short drives could have predicted the collapse. Nevertheless, the use of seatbelts turns out to be an important precursor indicator and should have led to revisiting the implementation of safety rules, thus possibly preventing the mine collapse.
In investing, we face a similar challenge pinning down the links between a range of indicators and material ESG issues. Still, by collecting and monitoring ‘safety rule’ breaches of ESG indicators, we hope to uncover issues which may otherwise be missed.
Before its share price was suspended, Huishan had received only 7 points (out of 100) in our survey. The average score in our universe is 44. There are cases in which our investment process requires a higher rate of return to justify investing in a company with such low ESG scores, and other instances, such as the Huishan case, the number of red flags simply render the company uninvestable.
As active investors, it is incumbent on us to analyze corporate governance incidents and learn lessons from them. It is worrying, however, that an increasing part of the market is not set up to evolve and learn the lessons of governance risks. In a 2015 scandal, which had striking resemblances to the Huishan case, Hanergy Thin Film went into suspension shortly after its share price had spiked by 539% within a year. Three ETFs followed the company into suspension – to these passive vehicles it did not matter that at its peak Hanergy was worth more than the rest of the Chinese solar sector combined. Due to inability of passive strategies to learn lessons from previous incidents, we expect to see further mispricing of not just governance indicators, but ESG risks in general.
The lessons learned
The circumstances leading up to the Huishan and Hanergy share suspensions were strikingly similar. Most obviously, both companies were tightly controlled by their founders. However as suggested above, these circumstances are not enough by themselves to lead to a corporate governance incident. So looking further along the causal chain, what did we see that might be precursors to the outcome?
1. Both companies were highly levered and destroying value.
2. Both companies had founders which had pledged their shares as loan collateral.
3. Both founders used these to pay themselves through dividends or personal loans.
4. Both companies paid low tax rates and had off-shore or Hong Kong holding companies to facilitate these transactions.
5. Both founders built up significant shareholdings before the crash.
Focusing solely on insider transactions for a moment, we will analyze two other governance failures, at OGX Petróleo and African Bank Investments Limited (Abil).
In June 2012, OGX announced that production at a major oil field would be 75% lower than expected. Shares fell 45% in two days. OGX subsequently abandoned several exploration fields and went into bankruptcy in 2013. Substantial insider transactions preceded these events, after a report by independent auditors in April 2011 had raised the first significant doubts on the company’s reserves. In the case of African Bank Investments Limited, founder and CEO Leon Kirkinis sold the equivalent of USD 4.4 million in shares in November 2013 to participate in a rights effort to save the bank. Prior to that, insiders had been buying shares leading up to the first major slump in Abil’s share price in early 2013.
Taking insider transactions as a stand-alone indicator (i.e. the volume of buys and sells by insiders) shows that the quartile of companies with the highest insider transactions underperformed other shares in the emerging markets universe by 187% in the last 10 years. This observation supports the idea that insider transactions are an interesting candidate in our ESG Survey as a further ‘precursor indicator’. Although further tests should be done to confirm this, we will start collecting insider transactions data as a potential governance red flag within our ESG Survey.
Taking together the indicators from the ESG Survey for which historical data is available, shows that the top quartile performers of our survey’s indicators showed 55% higher returns than the lowest quartile over the last ten years. This confirms the importance of integrating ESG into emerging markets investments.