How frequently have you heard of the following terms over the last 12 months: ESG, ESG integrated, impact, thematic, responsible investing, sustainable investing, ethical investing? If you tend to group all of these terms together, you are probably not alone. As I write this post, I’m sitting in the airport in Zurich, where I’ve been meeting prospective clients. At the start of one meeting here with a family office, the principal sceptically stated, “oh, not another sustainability fund!” Wariness from clients today is unsurprising given the vast number of terms which are thrown around in the public domain, combined with an abundance of products which are somehow linked to ESG.
However, the active ownership approach we take at Mobius Capital Partners is differentiated from mainstream sustainability investing. Our investment philosophy focuses on actively improving governance standards and delivering a clear ESG pathway for our portfolio companies in emerging and frontier markets. As we have previously written about governance issues [see post “Governance is Key” by Mark Mobius], in this post, I will focus on how we approach ESG integration, and in particular, how environmental and social factors impact pricing, growth, cost savings, and risk.
Whilst there has been considerable progress in Europe and the U.S. with regards to ESG standards, many companies in emerging and frontier markets lag behind their peers in developed markets. This is particularly true in small and mid-cap companies in emerging markets which are often run by entrepreneurs and families. These companies are more likely to suffer from poor investor relations, sub-optimal corporate governance, and provide limited protection to minority shareholders. What does this therefore mean for active investors like ourselves? The approach one takes in these markets requires rigorous research and a tailored engagement plan. Our bottom-up fundamental research considers all relevant information which can improve a company’s operations. We do not constrain ourselves to conventional definitions of ‘ESG’ but also assess political, macroeconomic, legal, and accounting factors. As global emerging and frontier market investors, we are cognisant of the variation of regulatory frameworks throughout our investment universe. Accordingly, we do not employ a blanket policy across our investments, but rather, focus our efforts on our customised active ownership strategy, which assesses companies on a pragmatic case-by-case basis.
There are essentially two elements to this approach:
Our area of engagement is very broad, but is focused on increasing long-term shareholder value. Potential governance improvements may be made in, but are not limited to: capital allocation, management remuneration structures, board independence, balance sheet restructuring, investor relations, capital structures, acquisitions, and divestures.
When we identify such problems through deep research, we address these in private meetings by partnering with management teams, boards, and controlling shareholders. We strongly believe that a regular constructive dialogue is the bedrock of the active ownership approach we pursue.
- Environmental and Social
Our analysis goes beyond assessing pure environmental and social factors. We recognise that each company and sector presents unique environmental and social challenges. We focus on how these can be improved and how this can have a positive impact on long-term financial performance. This encourages us to concentrate on material factors such as selling practices, energy efficiency or employee relations. These can, in turn, impact operational areas such as pricing power, market share, operating costs, employee retention, and productivity.
We believe environmental and social factors can impact emerging market companies in the following ways:
1) Pricing: companies with strong quality assurance, a robust and transparent supply chain, high quality labelling, and packaging will often benefit from a stronger brand over their peers. This allows companies to charge premium prices, and accordingly, benefit from both topline growth as well as the ability to offer higher margin products or services. Taking the infant milk formula sector in China as an example, it is evident that poor supply chain and quality standards, combined with suboptimal health and safety standards hurt domestic Chinese players in the sector. During the melanine scandal in China in 2008, more than 300,000 babies became sick or were hospitalised. As a result, millions of Chinese consumers lost trust in domestic brands and turned to premium foreign brands. The top 20 foreign infant milk formula companies in China increased their market share from 35% in 2007 to over 53% in 2017. At the same time, domestic brands witnessed their market share decline from 41% in 2007 to 30% in 2017. It is also worth noting that prices for infant milk formula have almost doubled over the past 15 years.
2) Growth and cost savings: companies with a market leading sustainability profile will benefit from a powerful brand which allows them to grow faster over their peers. Such companies benefit from growing their market share whilst potentially expanding into new categories and segments. For example a bank in Bangladesh which is known for microfinance lending to women has seen faster loan growth compared to its peers. Companies which run their business operations in a sustainable way should also benefit from higher margins and profitability. Whether this relates to reducing their input costs by lowering their utility bills to increasing productivity by lowering employee turnover. One example of this is an Indian beverage company which has seen a 600bps improvement in its gross margin due to lowering its water usage and offering customers the opportunity to recycle bottles. In resource constrained markets, such measures are critical to optimise efficiency whilst yielding tangible results for shareholders.
3) Risk: a body of recent research shows that companies with high ESG credentials benefit from a lower risk premium. This is captured via a lower cost of capital, lower business risk, as well as better access to financing. One example of this is in the banking sector, where we now see several emerging market banks assessing the ESG credentials of companies before they underwrite corporate loans. Companies with higher ESG standards are accordingly benefiting from a lower cost of funding.
Evidently, integrating environmental and social factors into an emerging and frontier markets portfolio entails more than relying on quantitative scoring and third-party research. It requires a deep understanding of the business, a thorough analysis of what drives value and a strong awareness of a company’s resource productivity.
During our many years of investing in emerging and frontier markets, we have observed a strong link between ESG engagement and improvements in the financial performance of our portfolio companies, particularly in the small and mid-cap sector. We strongly believe that capturing the improvement in ESG standards in emerging and frontier markets offers a greater opportunity to generate long-term returns whilst simultaneously mitigating risk.