“As a responsible investor, we also examine a dairy producer’s environmental impact, including whether it has a plan for achieving net zero.“
These are fundamental questions for a prospective investor in the dairy industry, which play a central role in consumers’ relationships with food and agriculture worldwide. They can be even more important in emerging markets, where countries can face specific issues of their own, including scarce water resources, high temperatures and a fragile infrastructure.
We have previously highlighted the opportunities we see in the dairy markets of the developing world, including increasing rates of consumption. We have also discussed how we approach the industry as a responsible investor.
In this follow-up article, we’d like to talk about the fundamental concepts we employ when we consider whether to invest in emerging market dairy providers. We don’t always decide to buy. There are big differences between the leading players in the market, including in their environmental footprint and where they are on the path to becoming net-zero in carbon emissions.
When we think about investing in a dairy company in an emerging market, we don’t look at it in isolation – investors have to take account of the wider risks a business faces operating in its sector. These include prevailing weather conditions and energy resources, presence of government subsidies and the robustness of the distribution chain. We need to be confident that a company has a coherent approach to handling the specific risks of its market.
“When we think about investing in a dairy company in an emerging market, we don’t look at it in isolation”
When we drill down further in our investment due diligence, we look at the strength of a company’s business model, its credit quality, balance sheet, approach to remuneration and management incentives, as well as its willingness to engage in constructive dialogue with institutions such as ourselves.
As a responsible investor, we also examine a dairy producer’s environmental impact, including whether it has a plan for achieving net zero.
To illustrate our approach in considering whether to invest, let’s look at three examples.
Almarai is the largest dairy company in the Middle East and a dominant player in Saudi Arabia. The company operates a vertically integrated business model, meaning it directly owns much of its production process. In the case of Almarai, that involves very large ‘warehouse style’ dairy farms in a region where water is in very short supply. The company imports its feed, or fodder, from around the world, including from California in the US. It has previously relied on government subsidies in this process.
Although Almarai is a well-managed business, with a strong brand name and position in its markets, our analysis raised some concerns, including over the way that it allocated capital to dairy farms and its sizeable investment in chicken production.
The risk of water stress in Saudi Arabia is ‘extremely high’, according to the World Resources Institute, which ranks the country at number eight in its table of the most vulnerable regions globally. The WRI forecasts that the situation in the country is likely to deteriorate.
Given our concerns about this, the sustainability of Almarai’s business model, and questions over its capital allocation, we decided not to invest.
Sadafco, or the Saudia Dairy & Foodstuff Company, was founded in 1976 and is a leading player in the UHT, or long-life, milk market in Saudi Arabia. It also makes cheese, butter, ice cream and powdered milk, as well as other food products. The company has been listed on the Saudi Arabian stock exchange, the Tadawul, since 2005.
Given the WRI’s assessment of the risk of water stress in Saudi Arabia, we took the view that, in contrast to Almarai, Sadafco’s business model was sustainable. Its focus on UHT rather than fresh milk made Sadafco’s activities less water intensive. The company imported its milk powder from Europe and New Zealand and reconstituted it into UHT milk and other dairy products. As an added benefit, the distribution network for UHT does not need to be cold, making it more energy efficient.
We also liked the professional, pragmatic approach of the management team and decided that we would invest in the company. We retained our holding for six years, selling in 2019 in order to capitalise on Sadafco’s high market valuation.
Inner Mongolia Yili
The Inner Mongolia Yili Company, or Yili, is the largest dairy company in China and a leading player across markets in Asia. It makes a wide range of products, including milk powder, ice cream and cheese as well as bottled water.
We made our first investment in Yili in 2017 and still own our stake in the company. Our decision was based on numerous factors, including Yili’s strong potential for growth and its openness to improving its performance on environmental, social and governance (ESG) issues, where it is already a leading figure in China.
Yili produces some of the best, most innovative and trusted brands in its market, where its distribution is nationwide. The management team is experienced and takes a prudent approach to mergers and acquisitions, which we find appealing.
On ESG, we are particularly impressed by the group’s recognition of the risks it faces and its willingness to address them. We have held several constructive conversations with Yili around water usage, employee incentive plans, corporate governance and the measures it plans to take to address its climate impact, which include a recently published reduction target.
The road to net zero
The dairy market is a significant producer of greenhouse gas emissions. According to the Institute for Agriculture and Trade Policy, the world’s top 13 dairy farms account for the same level of the emissions as the whole of the UK, the world’s sixth largest economy. Despite this, however, in many markets the environmental costs of production are not priced into the dairy sector.
As more countries join the commitment to transition to net zero, it’s clear that the dairy industry will come under pressure to tackle its contribution, and we expect share prices to increasingly reflect sustainability concerns.
We have strongly encouraged dairy companies to set emissions reduction targets that are aligned with the goals of the Paris Agreement of 2015. We have also asked them to adopt the Science Based Targets Initiative (SBTi). This is a collaboration between the Carbon Disclosure Project, UN Global Compact, WRI and the World Wildlife Fund that defines and promotes best practice in science-based target setting. It also provides resources to make it easier for companies to adopt the targets, which it independently assesses and approves.
Dairy producers that have set SBTi-approved targets include Synlait, Fonterra, Danone, Nestle, Dairy Farmers of America and Arla.
At the same time, pressure is growing in emerging markets to ensure that supplies of food and nutrition are reliable, driven by the region’s growing populations. The populations of less-developed countries are expected to grow by 30% by 2005, according to UN projections, compared with just 0.5% in more developed economies.
As we have highlighted previously (insert link to pt1), dairy is a relatively cheap source of protein that is likely to play an important role in helping countries, particularly those in the developing world, address the challenges of malnutrition.
We think it’s important to bear in mind, however, that heightened consumer awareness of animal welfare and the environmental impact of dairy farming is putting the sector under more scrutiny.
In part as a result, there is significant growth in dairy alternatives taking place in the developed world. Sales of plant or nut-based drinks in the US rose by 9% between 2015 and 2017, according to the American Farm Bureau, for example.
For us as investors, this shows the importance of choosing companies that can diversify their product range and move into new markets to cater for changing consumer demand.
“There is significant growth in dairy alternatives taking place in the developed world. This shows the importance of choosing companies that can diversify their product range and move into new markets to cater for changing consumer demand.”
The trends in emerging markets in this area are far from homogenous as, like the West, consumers have differing cultural and food preferences. In China, for example, soymilk has long been a drink of choice, putting the country ahead of the more recent increase in appetite for the dairy milk alternative in Europe and the US.
In the light of the environmental risks, animal welfare concerns and changes in consumer attitudes, we have been investigating the impact that dairy alternatives are having and their potential for growth in emerging markets. Within our own portfolio, we have noted the increasing use of alternatives by companies including Yili and China Mengniu Dairy, also based in China.
Dairy companies in the emerging markets have much to do to reduce their climate change risk and better manage their impact on the environment. However, we are encouraged by the willingness of some to put greater emphasis on sustainability. As active, long-term investors in the sector we are keen to support them.
Our investment framework seeks out companies with sustainable business models, strong balance sheets, proven management teams and good corporate governance.
With climate change both a risk and an opportunity for dairy companies, assessing the sustainability of producers, and their willingness to discuss improving their processes, is a central part of the investment case for us.
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Find out more about our responsible investment approach to dairy investing in emerging markets.