International equities are playing ever more important roles in well-diversified portfolios. But managers selecting international stocks have in the past relied on much the same investment analysis they perform on domestic securities. And there are limitations to that type of analysis when they are evaluating companies in multiple countries.

Specifically, country information is generally not considered in investment decisions. Every country is governed by different laws, and companies tend to follow the laws of a country. That has a strong influence on their governance and operations (including their listing requirements, corporate structure requirements, accounting requirements, disclosure requirements, etc.). So using the typical analysis to compare a company from one country with that of another may be like comparing apples to oranges.

Thus, when looking at international equity investments, an investor must know for a given country:

• Do the financial statements accurately reflect a company’s position?

• Are shareholders protected and are there adequate controls?

• Can company leadership make decisions confidently … and without interference from a corrupt government?

The financial statements of companies in China, for instance, are not always reliable or accurate, so using that information to create forecasts of future financial performance is not always useful. When a company in Turkey has financial difficulties, investors are concerned about whether government officials or courts will respect their rights. When you’re considering an investment in Russia, the nature of the relationship between the company CEO and President Vladimir Putin tends to be more important than the financial statements.

In each of these examples, country-specific considerations have a material impact on the value of companies, something traditional investment analysis doesn’t take into consideration.

Understanding country governance requires more than financial data. Governance should measure a country’s ability to create an economic, legal and regulatory environment where output can grow, investment opportunities are attractive and investor rights protected. The required information is not easy to find or incorporate into investment decisions. What is required is a systematic and repeatable technique for collecting and processing country data, while organizing it into a format suitable for guiding investment decisions.

The value of this type of country analysis can be significant and have much greater impact on portfolio performance than security analysis.

Marshall L. Stocker, a CFA, global macro equity strategist and portfolio manager at Eaton Vance, says that empirical evidence shows “country selection explains at least half of an international equity fund’s excess return.” So investors, he says, should select fund managers “whose primary or sole endeavor is to identify the correct countries into which an international equity fund should be invested.”

Good Governance = Honesty and Transparency

The more honest and transparent a country is with its citizens, businesses and investors, the more wealth is created in the country.

Studies have shown that countries that have an open, honest and transparent economy outperform those that don’t. It is important to collect and organize country-level data about the proven ability of their economic infrastructures to deliver honesty and transparency.

As Martin Gilbert, chief executive of Aberdeen Asset Management, says, “The governance of countries affects the ability of companies to generate value within them, and it is in everyone’s interests to enhance the framework for business.”

Canada and Australia, as well as the countries of Northern Europe, are generally considered to have good governance, and our firm gives them high rankings. Some of the small equity markets also provide attractive opportunities. In 2008, Denmark significantly strengthened its already-good governance, particularly in the areas of shareholder rights and key aspects of financial services regulation. Since it made those improvements, the country’s equity market has enjoyed annualized returns of higher than 50% over the past five- and 10-year periods ending December 31, 2016. Given the relatively small Danish equity market, a portfolio using market cap allocations would have relatively small exposure to such an attractive opportunity.

Ireland is another country that has improved its governance, and its market has also enjoyed an annualized return of more than 50% over the past five years (ending December 31, 2016).

Behavior Is More Important Than Intent

Just because laws and regulations are in place does not mean they are enforced. A key factor in determining good governance is to assess what really happens as opposed to what is supposed to happen according to rules and public statements. Behavior is proof of good governance, but measuring it is not easy. When deciding on metrics, investors must have a way to determine the country’s adherence to good governance practices in an objective and repeatable manner.

Many investors focus on the BRIC countries within the emerging markets (Brazil, Russia, India and China). Brazil for many years was considered the attractive opportunity because of its broad statements and sweeping intentions. But its subsequent scandals have shown that intentions were not enough.

By contrast, Hungary has received far less press and is noticeably smaller. Yet for the past decade, it has undertaken a variety of actions to strengthen its governance. Sometimes the implementation of those improvements was challenging. But between 2012 and 2014, the country became more effective, particularly in protecting shareholders and ensuring that financial statements were more accurate. In subsequent years, the country’s equity markets returned more than 30% annually through the period ending December 31, 2016. Once again, a portfolio based on market cap would have relatively small exposure to a country with improved governance behaviors.

Governance Is A Critical Driver Of Performance

In 2015, Gabriel Research & Management conducted a survey of trustees, finance directors, pension managers and consultants on the role of country governance in investing. The results reaffirmed its importance:

• 89% of respondents agreed that effective governance is a critical driver of investment performance;

• 57% believed that country governance regimes/competencies constitute a better measure of opportunity/risk than the traditional emerging/developed market definitions.

Erik Carleton, the director of pension investments at aerospace and defense conglomerate Textron Inc., said in the survey, “I expect my asset managers to take account of governance regimes in country-based investment analysis because it is going to affect a cumulative return of capital to shareholders.

“Things like rule of law in a country, portability of capital, restrictions on investing, money coming in or out and frictions that may be associated with that in either time or tax, are important,” he said.

Country Governance Indexes

Earlier this year, our firm created the first country-level governance indexes. Our database relies on 16 years of research, and it measures and scores all the investable countries in the world based on their governance. From this research, there are 12 standards and 280 factors that are analyzed to determine a country score, which ultimately determines the weighting in the index.

Within a country, traditional investment analysis conducted by professional managers is fine. However, when investing across borders, it is important to understand the governance standards and behavior within each country. Good governance focuses on the transparency and honesty of the accounting, regulatory and economic infrastructure and should be measured by looking beyond intentions to actual behavior. This insight and investment value can be worth the effort.        

Kurt Lieberman is CEO of Global Magni Asset.