Emerging Market Fund Managers should be the primary focus for listed companies
The importance of emerging market (EM) fund managers to listed companies in South Africa (SA) and other emerging markets cannot be under-estimated. Due to exchange control restrictions and local anchor investors (the PIC and BEE structures in SA), there is a natural demand for stocks. Local investors, especially in SA are not typically aggressively active (i.e. large funds are unlikely to take a 5x overweight position in a stock or have zero exposure to large listed counters). This means that local demand does not tend to fluctuate wildly, but shifts upwards or downwards based on operational performance and sentiment.
The marginal buyers for EM stocks (including SA stocks) are EM fund managers. Demand from this source can fluctuate wildly and is the primary driver of the stock ratings of listed companies. With the exception of index-tracking EM funds (which invests in all SA companies which make up part of the MSCI index), the vast majority of EM funds are very active investors. Many funds are cherry-pickers which mean that they identify a country to invest in, they allocate a portion of their portfolio to equities in that country and decide which industries to invest in and how much per industry. Within each chosen industry, the funds would then select a single counter to invest in.
Unlike local investors who are to a large extent captive shareholders, EM fund managers are spoiled for choice. EM fund managers can easily have an investible universe of stocks 3 times of larger compared to local fund managers. Where local fund managers may analyse 70% or 80% of the stocks in their universe and hold more than half of the counters, EM fund managers may actively analyse fewer than 10% of the stocks on their radar screens and invest in as little as 5% of all the stocks in their universe.
The difference between a company that is only on the relevant radar screens vs. on that is actively invested in, can be clearly seen in its shareholder register and its stock rating. In SA, we have seen numerous examples of companies that moved from on the radar screen to actively invested in, leading to a sharp increase in non-SA shareholding and an enhanced rating. There is a very high correlation between non-SA shareholding and stock rating, with high-rated companies like FirstRand and Sanlam having a very high offshore shareholding relative to their free float.
To achieve a healthy and sustainable re-rating of a stock, it is important to increase the proportion and absolute number of EM funds that hold it. Strong operational performance is useful to assist in this transition, but it is by no means good enough. It is vital that EM fund managers gain exposure to company research and management to help shift them from on the radar screen to actively analysed. This does not happen overnight and often takes 18 months to two years to deliver and then only if quality research is written and pro-actively marketed to EM fund managers.
The era of research unbundling has put significant pressure on stockbrokers, impacting coverage, quality of research and distribution effort. Many companies who only find themselves on the radar screens are increasingly not actively covered, are neglected when analysts interact with EM fund managers and are not being offered roadshows with EM managers. This situation will only deteriorate over time as unbundling becomes more pervasive.
Companies who ignore this threat and simply rely on their own relationships with fund managers (often very strong with local fund managers), may be in for a rude surprise as they lose share of voice to peers with more research coverage and distribution. The hurdle to displace incumbent shares has become significantly higher, while at the same time it has become much more difficult to attract new shareholders.
Companies that invest more aggressively in their investor relations divisions or can offer investment banks the possibility of secondary business, are likely to steal share of voice away from companies that do not. High-quality and independent issuer paid research can be an extremely effective method to improve share of voice relative to competitors. First movers in the issuer paid research field will gain a lead over their peers that may be difficult to narrow once in place.