Responsible Investing

Achieving an ESG Edge in Emerging Markets

As emerging market (EM) equities gain favour among institutional investors, Juan Salazar, Director and EM specialist, Responsible Investment, BMO Global Asset Management EMEA, explains the importance of integrating environmental, social and governance (ESG) analysis into investment decisions, and how it can be accomplished effectively to yield a valuable edge for EM portfolios.
November 2019

Juan Salazar

Vice President, Responsible Investment

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As emerging market (EM) equities gain favour among institutional investors, Juan Salazar, Director and EM specialist, Responsible Investment, BMO Global Asset Management EMEA, explains the importance of integrating environmental, social and governance (ESG) analysis into investment decisions, and how it can be accomplished effectively to yield a valuable edge for EM portfolios.

ESG Leaders Outperform in Emerging Markets

It should come as no surprise that over the last decade, the MSCI Emerging Markets ESG Leaders Index, which tracks companies with high performance in ESG metrics relative to their peers, outshone the broader MSCI Emerging Markets Index – with 6.98 percent annualized gross returns versus 3.73 percent.1 As shown below, this 3.3 percent gap would make a notable difference in any institutional investor’s portfolio; the results demonstrate consistent outperformance, with a remarkable gap of 6.7 percent in 2010, for annualized returns of 25.88 percent in the ESG Leaders index.2 If nothing else, the data supports the wide awakening around the general principle that a company’s ESG record must be analyzed to truly gauge overall potential for long-term portfolio success. This is especially pertinent for EM-based companies, which are often characterized by lack of transparency, or willingness to meet global ESG standards. In fact, a typical EM equity investor is exposed to about 14 percent more unmanaged ESG risk than a typical developed market equity investor, with the gap in data privacy and security the most significant.3

ESG Cumulative Performance

A key tenet of our philosophy at BMO Global Asset Management is that we are invested for the long term. That message permeates throughout our investment strategies, and fundamentally explains why ESG factors are integrated throughout our entire investment process – from idea generation all the way through to portfolio construction and active ownership. Within BMO LGM Global Emerging Markets strategy, the goal is to find high-quality companies that have sustainable business models, robust balance sheets, proven management teams – and that can demonstrate majority and minority shareholders’ interests are aligned. As part of this, our assessment of quality is informed by how well companies are positioned to address sustainability challenges – either from a product/service, or risk management, perspective. Not only is this aligned with our unwavering commitments for a thriving economy and sustainable future, but it also positions companies to benefit from growth opportunities, which can result in direct alpha generation and shareholder value creation.

ESG Integration: Quality Enrichment

With the support of our 17-strong Responsible Investment (RI) team, portfolio managers (PMs) and analysts at LGM – BMO Global Asset Management’s centre of expertise for emerging markets equities – are responsible for identifying what ESG drivers are material for investment performance over the long-term. Through open lines of constant communication, we provide original research that informs this investment analysis process. If, for example, PMs are looking at a shipping company in Hong Kong, we would analyze everything from the latest ESG developments in the global shipping industry to the impact on Asian trade routes. We would then identify outstanding areas of risk or opportunity that we think could be improved upon and would support our active ownership activities going forward. When looking at the lending activities of a bank, for example, we look at if, and how, material environmental and social risk factors are considered into the assessment of credit risks. We believe this can provide valuable insight into the true credit risk profile of a loan book.

This analysis could make – or break – an investment decision: in a recent situation within the global EM strategy, we owned an Indian bank that experienced several governance challenges which were not sufficiently addressed to protect our interest as minority shareholders, resulting in the abrupt exit of this position entirely. It was previously one of the strategy’s top holdings. Once companies like this lose favour among investors, their stock price can provide a good entry point for purchase; but in our view, serious long-term concerns, either from a management or ESG perspective, would always prevail over short-term opportunities. However, if PMs thought that the risks were manageable and/or low, then the RI team would work collaboratively with the respective company through ongoing dialogue to improve strategies and performance. Whatever the decision, ESG analysis forms an integral part of our EM strategy’s disciplined due diligence process, and reinforces our high-quality investment mindset from the start. ESG integration is about more than doing the right thing; it enriches the quality of our analysis, and ensures that we earn robust returns over time – regardless of whether markets are moving up, down or sideways.

BMO Global Emerging Markets Strategy: ESG and EM work together
Walmart de Mexico – the largest private employer in Mexico, with more than 230,000 employees The company has made significant efforts to improve overall working conditions through enhanced salaries and benefits; initiatives to promote diversity and inclusion; training and development investment; and stronger employee engagement practices.
ITC – one of India’s largest buyers and exporters of agricultural commodities ITC has adopted a strategic approach to manage climate change risks across its agricultural activities. Practices include mapping climate risks across key sourcing areas; investing in technological innovations, e.g., drought-resistant seeds and micro-irrigation systems; adopting a watershed approach manage water resources; working closely with farmers to test climate-smart agricultural practices and deploy social forestry programs; and collaborating with specialists on soil and moisture conservation practices.
Bank Mandiri – the largest bank in Indonesia in terms of assets, loans and deposits We have seen the bank take action recently to improve its ESG management practices across a number of areas, including credit risk and IT risk. Mandiri has developed a five-year Sustainable Action Plan focused on lending transactions to companies in four industries with high sustainability risks, including palm oil and energy, strengthening the quality of the loan portfolio. On cybersecurity issues, it has improved its approach to managing data security risks, and enhanced transparency and disclosure in its annual reporting.
Discovery (South Africa) – South African life and health insurer operating in seven markets Discovery’s Vitality client platform, which rewards members for adopting healthier lifestyles that can lead to lower claims and prevention of non-communicable diseases, has created a tool that provides useful information on customers’ behaviour and impacts on health. This can ultimately improve its ability to predict profitability and cashflow generations. It has also helped create an actuarial tool that links to the price of insurance, allowing members to save money by remaining active and eating healthy.

The Advantage of Global Reach, Local Expertise

From so many angles within the ESG landscape, EM are different from developed markets, but this can be an advantage for experienced PMs who know how to navigate the region. Many companies in the area are family-owned, or state-owned, which can make attaining information more difficult, especially since there is still some resistance to speak to foreign investors in certain developing economies. LGM specializes exclusively in emerging, frontier and Asian markets, and is keen on building long-term relationships – on the ground – with its target companies, facilitating easier access to information, and giving PMs a clear picture of companies’ operations within their own environment. Together with the RI team’s proprietary research (which is informed by international norms and conventions such as the UN Sustainable Development Goals), and data from external ESG service providers, we use this first-hand knowledge to focus on what best practices are applicable to companies on a case-by-case basis. The RI team is therefore able to translate ESG best practices into what is relevant for an individual EM business, and what we – as investors – think is required to achieve success over the long-term. What may be environmentally appropriate for a Western-based company may be miles ahead – or even unachievable – in an EM context, so a depth of understanding into the specific business, its fundamentals, and the industry is necessary.

Our RI team provides the tools required to ask the right questions; EM companies should understand that it’s not a dictatorship, or an imposition – but rather, a partnership. That is why BMO Global Emerging Markets’ bottom-up, fundamental analysis approach, and local expertise, is vital to its methods.  Our process is defined by a seasoned, diverse investment team: speaking the local languages, visiting executive teams in person and gathering information for thoughtful – and smart – asset allocation decisions. In Hong Kong, for example, we have four local investment analysts that can meet directly with companies in the region – from owners/managers to suppliers and other stakeholders, as a way to create a strong foundation for a future relationship. Given how few companies in EM report quarterly filings in dual languages, BMO Global Emerging Markets strategy is designed to uncover investment opportunities that add true diversity – and ESG value – to your investment portfolio.

Emerging Markets: ESG in the Spotlight

While governance has long been a prominent issue for EM (given the large number of family or state-owned enterprises, prevalence of related-party transactions and sometimes weak protection of minority shareholders’ rights), environmental and social challenges have just recently started to come to the forefront for institutional investors as asset managers have gained a greater understanding of these issues, and how they come to play into the long-term investment case.

Importantly, populations across EM have started to become affected by the impacts of ESG challenges. New scientific reports are proving almost weekly how vulnerable nations like India, the Philippines and Vietnam are to climate change – and many of these poorer economies do not have the resources to combat these problems. From Hong Kong to Malaysia, there has been a broad awakening among asset managers and investors, and as a result, there has been resounding interest in EM funds focused on ESG integration. Even anecdotally, it has been remarkable to see how the landscape has evolved over the last decade. Just 10 years ago, we could seldom have an informed, or constructive, conversation with an EM-based company about water pollution, whereas now there is an entirely different understanding that robust ESG management is actually a sound business strategy that can create value for the long-term.

Nonetheless, there is still a hurdle among some EM companies in persuading them that we’re not interested in whether they’ve donated large sums to charitable organizations, or built schools in underdeveloped parts of the world – however worthwhile these endeavours may be. Rather, our focus is on issues that are material to the business model. For example, when modelling the future cash flows of oil and gas firms, ESG considerations cannot simply be taken as an afterthought in investment analysis, especially as carbon pricing and other regulatory efforts gain steam worldwide.

ESG Integration: A Subject We Cannot Afford to Ignore

Despite mounting trade concerns between the U.S. and China over the last few years, non-resident capital flows to EM are projected to reach $1.26 billion in 2019, up from $1.14 billion in 2018 – with another modest recovery anticipated next year, according to the Institute of International Finance.4 As fund flows increasingly rotate into EM, a growing number of institutional investors have accepted that insufficient EM exposure can lead to missed opportunities for outperformance. Clearly, as seen above, the same could be said for ESG leaders as a source of alpha.

It makes sense to us that the EM companies most proactive in managing key ESG-related risks would enjoy greater business model resilience, lower risk, and reduced volatility. At its core, ESG serves as a vital risk and opportunity assessment tool that gives us insight into companies’ operational practices and performance – directly helping us support stronger long-term returns.

1 MSCI Emerging Markets ESG Leaders Index, September 30, 2019.

2 Ibid.

3 Sustainalytics, ESG Spotlight: Emerging Markets Equities: Key Sources of ESG Risk, August, 2019.

4 Reuters, April 2019.

 

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