In emerging markets, analysis of a firm’s negative and positive externalities are crucial for enhanced earnings visibility within a comprehensive financial valuation process.
Environmental, social and governance fund proliferation is usually fueled by the marketing mantra that investors can “do well by doing good.” While that’s no doubt true, ESG criteria are all too often a check-the-box exercise at both the fund and the company levels. Many ESG funds default to outsized tech holdings or include companies that talk the ESG talk but fail to walk the walk, otherwise known as “greenwashing.” Conversely, ESG data vendors often tag some firms with low sustainability ratings, even as those companies make genuine and concerted efforts to improve their sustainability. Should they be included in ESG portfolios?
Such “ESG momentum” plays can become great investments both in terms of their sustainability and return potential. But properly assessing their relative progress across sectors and culturally diverse geographies, particularly in emerging markets, is no easy task. We believe sound judgment is just as crucial in ESG research as in traditional financial research. Indeed, to be effective, we have found that ESG research is integral to the financial valuation process, from the idea phase all the way through portfolio inclusion of those firms that make the final cut.
Define Sustainable Return Generator
What makes one company more sustainable, and a greater return generator, than its competitors? How can ESG fund investors know whether sustainability focused portfolio managers are doing more than checking ESG metric boxes?
The question has become so pressing the U.S. Securities and Exchange Commission (SEC) in April issued a report warning that some ESG funds may not be very green or socially responsible.1 Some money managers may be misrepresenting their products to such an extent that they could be transgressing securities laws, namely those that don’t really have a thoughtful and thorough ESG research process. That may well be the case among those now sprinting to market with newly minted ESG products in a bid to cash in on fastgrowing investor interest.
“In response to investor demand, investment advisers and funds have expanded their various approaches to ESG investing and increased the number of product offerings across multiple asset classes,” the SEC’s “Risk Alert” noted. One observation stands out:
This rapid growth in demand, increasing number of ESG products and services, and lack of standardized and precise ESG definitions present certain risks… the variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms, especially when offering products or services to retail investors. Actual portfolio management practices of investment advisers and funds should be consistent with their disclosed ESG investing processes or investment goals.
We agree. As ESG investors for years now, we examine company-provided ESG data, third-party ESG ratings and have developed our own proprietary ESG research, which taken together facilitate greater clarity on a company’s current level of sustainability as well as its trajectory, providing greater context for interpreting cost of capital, discount rates and ultimately earnings visibility.
In the following Q&A, Thornburg Portfolio Manager Charlie Wilson, who co-leads an ESG-focused emerging markets strategy, as well as the firm’s other emerging market strategies, explains how the team defines and conducts ESG research, which is part and parcel of its traditional financial research and ongoing company monitoring.
Q: Many ESG-focused funds seem to start with negative screens that simply filter out companies in potentially problematic industries, such as gambling, tobacco, alcohol and hydrocarbon-focused energy firms. How does the team go beyond simple screens? Why do the qualitative and quantitative components that comprise your ESG and financial due diligence matter?
CW: Our research broadly aims to capture the costs of both positive and negative externalities. That’s why we don’t just conduct negative screens. Positive externalities can be reflected in lower cost of capital thanks to decreased liability risks, while negative externalities can manifest in higher capital costs due to, say, high energy intensity, water usage or greenhouse gas emissions.
Enhancing traditional financial analysis with extensive ESG-derived metrics gives a fuller financial picture, which can inform a more realistic discount rate and allow for more accurate earnings and cash flow projections, in our experience. Generally, we just think companies whose strategy or business model is based on amplifying positive externalities while reducing or eliminating negative externalities will benefit from higher confidence in the sustainability of free cash flow generation, a lower cost of capital, and the potential to increase reinvestment opportunities over time.
As owners of these companies, we anticipate that these characteristics should support excess returns, as the market over time better appreciates the durability of their financial performance and the resilience of their business models.
Figure 1 | Value vs. Growth Equities Performance Rotation Occurs Frequently in Emerging Markets
Benchmarks Reflect Current, Not Future, Opportunities
Q: Some markets appear more efficient than others in pricing in all available information, which in theory is reflected in share prices. How efficiently does the market price in both ESG and financial valuation metrics? And why do some markets appear more efficient than others, say U.S. equity benchmarks versus EM counterparts?
CW: Well, we don’t find that markets in general are very efficient with the assessment of risk and reward, and that’s likely due to the typically siloed nature of security analysis. That’s also why we observe that portfolio allocations driven by benchmark composition are also inefficient in the assessment of compensation for assumed risks. Benchmarks reflect the structure of the current investment universe, but they clearly don’t reflect the future opportunity, or potential impact associated with including all internal and external costs of operating a business. These inherent inefficiencies provide a robust environment for active managers.
Q: Apart from the inefficiencies within the asset management industry itself, doesn’t market volatility within emerging markets create a particularly favorable environment for truly active managers? These regions have less mature capital markets and a smaller institutional investor base; they have higher economic cyclicality and currency volatility; more regulatory and political risks, not to mention uneven ESG standards. The high frequency of factor rotations between growth and value in EM in a way also speaks to the volatility in the space.
CW: In many situations, these elements also work together to amplify investor optimism or pessimism, driving stock prices farther away from fair value than might be observed in developed markets. In EM these inefficiencies and dislocations exist across sectors, geographies, market capitalizations, levels of business quality, and investment styles such as value, growth and quality. We aim to exploit these inefficiencies by marrying each investment team member’s broad expertise, deep fundamental analysis, and insights on non-financial business characteristics with the ability to assess the impact of externalities and better gauge risk and reward across a huge opportunity set—the index alone comprises more than two dozen countries.
So, our team structure requires us to have a broad understanding of investment opportunities across sectors and geographies, but at the same time everyone must remain flexible about the characteristics of companies they propose for inclusion. Because of the higher levels of risk and uncertainty in emerging markets, we want stock selection and portfolio construction to help mitigate risk from stock-specific dynamics and from longer-term external risks. We believe this allows the portfolios to participate in emerging markets’ structural opportunity for capital appreciation, while reducing risks from lower transparency, or legal, regulatory or climate regime changes, or industry disruption.
Figure 2 | Emerging Markets appear to carry higher ESG risk ESG ratings bands by region (as of 31/12/21)
* Based on the Eurozone domiciled segment of the MSCI World Index
Source: FactSet and Sustainalytics
The Attributes of a Strong Company
Q: How does that work at the stock level?
CW: In our stock selection process, we focus on vibrant companies with attributes that we believe mitigate business-related risks: durable firms with a leading or growing market position; strong, quality leadership and governance; and the ability to fund their own growth, so they are usually free cash flow positive. They must also trade at attractive prices for us to establish or add to a position, so we also have some margin of safety.
We also build in a macro overlay due to currency risk sensitivities, which depend largely on domestic current account or fiscal deficits, or both, local benchmark interest rates and inflation. In these instances, the price targets of our positions must meet, if not exceed, our return hurdle rates based on potential local currency depreciation, as our investors are mostly U.S.-dollar based. But there are always at least a few great companies to be found in countries that are passing through a rough patch economically; those firms that demonstrate resilience in the tough times tend to thrive over full market cycles and can be excellent investments.
Lastly, every position must offer a “path to success,” catalysts or milestones that should propel it to close the discount we see in our assessment of its intrinsic value. Having clear milestones makes it easier to track the progress of our investment thesis on each stock in the portfolios.
Volatility Aware, But Focused, Diversified Portfolios Aim for Longer-term Return Potential
Q: You run rather concentrated strategies of just four to five dozen positions. Doesn’t that generate greater volatility at the portfolio level? How does your portfolio construction process address that?
CW: Well, again, it starts at the stock level. You would be surprised how a strong company in a promising market can not only survive but thrive in challenging economic times, taking share from other, less thoughtful competitors that don’t address the needs or interests of all stakeholders. By the way, those include not just clients, shareholders and majority owners, but obviously employees, suppliers and local communities. Now at the portfolio level, we think we can better achieve our performance goals by making larger, more meaningful investments in a highly select, and well diversified, set of our best ideas. By focusing capital in our highest-conviction stocks, our portfolios naturally have fewer holdings, larger average weights, and more capital in the top ten positions, which usually make up just more than 40% of the portfolios.
So, on portfolio construction, while we’re always aware of absolute and benchmark- relative volatility, for us it’s rather secondary to the longer-term return potential of the portfolios. We do think our portfolio construction helps to mitigate the impact of volatility by diversifying our investments across market segments with different underlying business drivers. Given our stock selection, the portfolios tend toward quality and growth, but their diversification goes beyond standard country and sector parameters to focus more on the business drivers. Specifically for our ESG focused EM strategy, we group the various business drivers into five different categories that we have identified within the United Nations’ Sustainable Development Goals. The category target weights are based on our view of the importance of each within a global emerging market context today and in the future.
Q: What are those categories and their respective weightings in the portfolios?
CW: “Sustainable Consumption,” which runs from 15% to 30% of the portfolios, has a rough corollary in consumer discretionary and staples. “Financial Inclusion” has the same 15% to 30% weighting range and has some of the same traits as conventional financials, IT, communication services and consumer discretionary. “Digital Services and Technology” is bigger at 25% to 40% of the portfolios, and has elements of communication services, consumer discretionary and IT. “Health, Wellness and Education” is a bit smaller at 5% to 20%, and obviously has health care, but also some consumer-staples and consumer discretionary-type traits. And the last one is “New Energy and Infrastructure,” which is also weighted at 5% to 20% of the portfolios, and has some overlap with energy, industrials, materials and consumer discretionary.
While these categories span the traditional sector classifications, our focus on our portfolio holdings’ discrete business drivers helps ensure that they’re all classified and diversified based on their sustainability in providing goods and services that amplify their positive impacts while working to minimize any negative externalities. So, while our positions may have different lines of business, they all exhibit sustainable growth, and brought together in focused portfolios, we think they mitigate absolute and benchmark-relative volatility while generating strong, long-run returns.
- Risk Alert, Division of Examinations’ Review of ESG Investing, Securities and Exchange Commission, 9 April 2021.