Taking the high road to emerging markets

With volatility and dispersion increasing in emerging market equities, long-term investors can guard their portfolios by actively integrating ESG into their decisions.

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Despite concerns over the strength of the US dollar, domestic political uncertainty and fears of a US versus China trade war that have rattled emerging markets in 2018, this is an asset class that will likely become increasingly important for investors in the long term.

When comparing regions on a purchasing power parity basis, gross domestic product for emerging economies represents 59 per cent of the global total; a 23 percentage point increase over the past 30 years, according to the International Monetary Fund.1

The growing influence of EM is also reflected by relative investment performance over the long term, as shown in the chart below. The annualised return of EM equities since the start of 2001 is about 9.26 per cent for the MSCI EM index, compared to 5.33 per cent for the MSCI World and 5.43 per cent for MSCI ACWI indices.

Cumulative index performance (US dollars)
graph 1

Interestingly, returns for companies seen as leaders based on environmental, social and governance (ESG) factors are even higher. The annualised return in the ten years ending 30 September 2018 was 9.07 per cent for the MSCI EM ESG Leaders index, compared to 5.4 per cent for the MSCI EM index during the same period. (See the chart below.)

Cumulative index performance (US dollars)
graph 2

Not traditionally a first port of call for EM equities, ESG integration is an area in which active management can make a big difference by taking advantage of potential risk-return opportunities. The reasons include the following:

  • Increased scrutiny in the aftermath of major scandals, such as those involving Brazil’s Petrobras and South Korea’s Samsung Group, is ushering in the potential for further reforms that strengthen the case for ESG improvements in emerging markets.
  • EM companies are doing more to attract international investors, catering to higher ESG standards and global best practises.
  • ESG disclosure has far to go in the EM universe, but is improving and offers opportunities for investors.

In the first part of a new Q&A series on how ESG is evolving in EM equities, Alistair Way, head of global emerging market equities, and Will Ballard, head of emerging market small-cap equities, discuss how ESG integration can help reduce risk and extract outperformance. Over the next few months, we will look closely at ESG developments in specific countries: Malaysia, China, Brazil, South Korea and India.

What are the key differences in the way EM companies approach ESG versus developed market companies?

Alistair: Speaking broadly, the standards of ESG are lower, with a wider variety of constraints and influences in emerging economies. On top of that, governments usually have a greater role, with state-owned companies subject to significant interference in their operations. There’s also a higher concentration of ownership, with many companies dominated by family or other private interests, and hence under less pressure to adopt best practise on issues like board independence.

Lastly, any ESG approach to emerging markets must take into consideration the different stages of development. We are seeing steady progress, albeit with variations at the country, sector and company levels.

What is driving change?

Alistair: In terms of governance, the rising influence of international shareholders is a key driver. EM companies wishing to tap into international capital markets are increasingly scrutinised for their governance standards, with many global investors placing more emphasis on activism and voting.

Environmental and social progress is subject to a wider variety of influences. In certain countries, for example China, a greater domestic focus on issues such as pollution is helping to push for reforms at the government and company levels. Global consumer and media scrutiny of companies’ supply chains are another significant driver of positive change; companies need to ensure their environmental and labour standards are uniformly high to be able to tap into the western consumer supply chain, particularly in sectors such as electronics and textiles.

How has a more globalised economy impacted ESG practices of EM companies?

Will: Significant regulatory changes are being imposed across borders. In the textile industry, rules of origins requirements that are driven by what customers are demanding in the US and Europe do not necessarily stop at the border. Supply chains are now global, affecting EM companies in a completely different way than you might expect in terms of country or geography. Even when you look at local regulations, you need to think more broadly about the global ramifications. A company based in Malaysia selling into Europe, for example, will need to heed the European Union’s environmental regulations.

How can ESG integration help protect investors in a riskier environment?

Alistair: The main drivers of EM share prices at the moment tend to be global macro factors, but to generate sustainably strong investment returns for clients over the medium term, we need to understand what the key company and industry-specific drivers are. ESG is an important part of that.

By monitoring and engaging with companies across a wide range of ESG indicators, we increase our confidence that they can thrive over the medium term.  Of course, in a risky environment like we are currently experiencing, stock-specific risk events such as a corporate governance problem may be particularly punished by the markets, so ESG considerations become even more important. We know companies that exhibit higher ESG improvements relative to their peers tend to be rewarded for their operational efficiency and higher resilience to certain risks, including labour, environmental and accounting problems.

How can investors take advantage of ESG as a way to enhance returns?

Will: There is a significant body of evidence suggesting that EM companies with the best governance have been long-term outperformers. It also seems highly plausible from a bottom-up perspective that improvements in ESG are likely to be rewarded by the market, as companies make themselves more operationally robust and appeal to a larger number of international investors. Improvements in disclosure have given investors more access to information that can be used to identify opportunities, especially as companies progress in their ESG practises. By embracing ESG analysis as a key driver in stock research, we can improve our chances of enhancing returns.

Can you give an example of how investors might be able optimise returns through ESG?

Will: One of our holdings is in a Malaysia-based company Hartalega Holdings, which is a manufacturer in nitrile gloves used in the medical industry. When we analyse such a company, we consider how the industry it operates in is changing and the drivers of that change. As the biggest manufacturer of high-end disposable nitrile gloves in the world, a majority of its revenues come from the US and Europe, where stricter environmental regulations are being introduced.

Over the years, Hartalega has consistently invested in best-in-class facilities that meet or exceed environmental standards; reducing its use of natural resources. Its health, safety and environmental performance regularly outpaces many of its peers, and it sets aside four per cent of annual profits to invest in equipment and technology to help protect the environment. The air emission levels of its scrubber towers, for example, are up to 20 times lower than the regulated standards. The result is a potential competitive advantage when standards and regulations change. By understanding these kinds of dynamics, we believe we can improve the return prospects for clients.

ESG integration is so broad, where should investors start?

Will: We start by establishing precisely which ESG indicators are of greatest importance to clients and to our own principles, based on proprietary and publicly-available sources such as Moody’s global heat map reports. This highlights the risks of corporate malfeasance to be avoided. We then use a robust framework for tracking and focusing on these indicators across every company we invest in. This needs to be a key element of the stock selection process, ensuring full engagement between the ESG and investment teams, rather than a box-ticking exercise. Thinking about ESG in a more methodical, rounded way requires a depth of resources, and we believe this approach will be rewarded over time.

Are there certain priorities that should be taken, for example, focusing on the E, S or G?

Alistair: Given the state- and family-owned nature of many EM companies, the governance aspect is an obvious place to start; applying a ‘red flag’ system to highlight risks of corporate malfeasance that should be avoided. This is beneficial in terms of mitigating risks (corporate governance abuses are more frequent in certain emerging markets) and obtaining investment upside.

As EM companies move minority shareholders up the priority list, focus on better disclosures and implement more generous dividend policies, they should trade on higher multiples. That risk is almost automatically discounted for EM companies, so if we can reduce those risks, valuations should be higher. Then, if we can expand the investment decision-making process further to include environmental and social considerations, we can embrace a broader range of risks and opportunities.

References

GDP based on PPP, World Economic Outlook published by the International Monetary Fund, October 2018.

Important information

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