Episode 20: To Find Fertile Ground in Emerging Markets, Incorporate ESG

Portfolio Manager Charlie Wilson explains the importance of employing ESG analysis in identifying companies that are good stewards of their resources. They tend to be higher-performing firms, particularly in emerging markets.


TD0549 To Find Fertile Ground in Emerging Markets, Incorporate ESG

Charlie Wilson: ESG considerations, in general, are a fertile ground for active management. It really just speaks to the fact that this is a judgement that’s really left up to the investment professionals if executed properly. And so, that’s part of the reason why, at Thornburg, we’ve decided to have all of our investment professionals perform the ESG analysis in order to consistently incorporate that into our security selection.


Charles Roth:    Welcome to another episode of “Away from the Noise” Thornburg Investment Management’s podcasts on key investment topics, economics, and market developments of the day.  I’m Charles Roth, Global Markets Editor at Thornburg.  We’re joined today by Charlie Wilson, who runs our developing world equity strategy as well as our emerging market ESG ADR strategy.  Welcome Charlie.


Charlie Wilson: Thank you.  Thanks for having me.


Charles Roth:    I’d really like to explore ESG particularly within the EM space.  Generally, ESG products are usually marketed as a way to do well by doing good.  You know, it’d be nice to hear how you integrate ESG into your core developing world strategy, as well as how ESG fits into your dedicated EM ESG strategy.


Charlie Wilson: Yeah.  I guess, first of all I would start off and say that we don’t feel like you have to sacrifice return to include ESG as part of the process.  Our approach to ESG has evolved through experience over time, and I say that because I think any successful investor has to be introspective.  They have to reflect on their mistakes.  They have to understand what they can do better next time, and that’s really helped us to improve our process over time.  And one component of that has been to include ESG considerations into our process.  You know, most people say that it starts off with governance, and really that’s the proper oversight of the, of the company that you might be investing in, but over time that’s evolved also to include considerations around human capital resources as you might expect from the, from the social side.  Every business has access to a finite set of resources and you want to see them use them as efficiently as possible, and that might labor, it might energy on the environmental side.  And what we found is that companies that are good stewards of their resources are also tending to be higher performing companies.  And so, it helps guide us to find those best-in-class companies, and it all, also helps us have confidence to build large positions behind them.  And so, we view it as enhancing returns, not sacrificing returns to include ESG in, in the process.


Charles Roth:    Can you walk us through how ESG factors, I guess alongside the traditional financial valuation and analysis of, of a business?  So, I would imagine that – you mentioned energy.  Perhaps water usage could be another measure.  Those are no doubt externalities.  So, how do you view externalities?  How do you incorporate those, both positive and negative externalities into your analysis?


Charlie Wilson: Yes.  It’s, it’s a good question.  I, you know, if you look at traditional financial analysis, which most fundamental investors use in their process, it very narrowly defines a way that a company should think about resources.  And it’s, it’s things that can reflected in, in an income statement or a balance sheet or cashflow.  But the reality is, is that a company has an impact on not only their, their end-customers, but also a broader set of stakeholders, including their employees and, you know, the local population where their, their businesses may be located.  And those kinds of considerations of, you know, those impacts, those broader impacts may negatively or positively impact the outcome of the company, which would ultimately get reflected in the income statement, but it might be something that’s harder to see up front.  You know, that might be a heavily pollutive company, it might impact their future customers if they don’t manage their waste properly, for example.  The traditional financial analysis would focus on shorter term results, but some of these things that we’re talking about actually have longer term implications.  Which unless you’re including them, you know, in the process up front, you may over or underestimate the value of that business in the longer term.  And since we’re long-term shareholders, these kinds of considerations become increasingly important, especially as we’re starting to look at tighter regulation, greater scrutiny around some of these issues, which could ultimately lead to either higher regulatory costs or higher legal costs down the road.


Charles Roth:    So essentially, you’re, you’re looking for a more-full comprehensive understanding of a company’s costs, their efficiencies and, therefore, perhaps given the, the liability management issues that you were kind of alluding to just now.  Their costs of capital, perhaps future discount rates, projected cashflows, earnings, and return potential those, those all feed into essentially the outcomes that you’re looking for.


Charlie Wilson: Absolutely.  So, our longer time thesis on the importance of ESG is that companies that utilize, as I mentioned earlier, that companies that utilize their resources well, and that includes not only traditional, resources identified through traditional financial metrics, but also the broader spectrum of resources like human capital and, and so forth or, or energy and, and materials.  The importance of that is that those that are the most efficient, i.e., limit the negative impacts on their surroundings, and perhaps amplify the positive impacts, so produce positive externalities, which benefit all stakeholders, not just customers or employees.  Those companies will be rewarded with better share price performance, better operational performance, and a lower cost of capital over time.  And that, that might take some time to play out, but ultimately the rules of basically many companies are changing and they need to be adaptable and understand how to navigate in that environment, and those that are successful will be rewarded.


Charles Roth:    So, in both your strategies, are you benchmarked against the standard MSCI EM Index, or for the EM ESG ADR strategy?  Is there a different benchmark?


Charlie Wilson: Yeah, both strategies are indexed against MSCI EM.  And the primary difference between the two is the core strategy, the, the developing world strategy, the strategy that’s been in place for some time, that is ESG integrated and includes these considerations into our investment process.  But we don’t exclude companies solely on their ESG score.  So if the company is appropriately valued or attractively valued, and we take these additional risks related to ESG into account and it still looks attractive, we will make the investment.  Whereas, in the ESG equity product, that focus is, is on companies that do score well on ESG, as well as the additional hurdle of having a positive impact; so a positive externality on stakeholders.  And that goes to that longer term thesis of believing that their cost of capital and their share price performance will be tied to their effective utilization of resources and the positive impact that they’re creating for their, for their constituents.


Charles Roth:    So, in the conventional index, so the MSCI EM Index, I would imagine because there’s not a sensitivity toward measuring in various ways the impact on costs of positive and negative externalities, that index must be rather inefficient.  And the other index, perhaps, is less efficient given that they’re sort of constructed in a backward-looking way.  Both these areas I would imagine are fertile ground for, for active management.


Charlie Wilson:                I would say ESG considerations in general are fertile ground for active management for a variety of reasons.  One is that the investment industry has not decided on a consistent set of standards of how to assess and rate companies according to ESG criteria.  Secondly, even on, among the third-party providers there’s a lot of discrepancies or, or confusion, because some companies are rated highly by one and maybe they don’t receive as high a score from the next third, third-party provider.  And so, it really just speaks to the fact that this is a judgment that’s really left up to the investment professionals, if executed properly.  And so, that’s part of the reason why at Thornburg we’ve decided to have all of our investment professionals perform the ESG analysis in order to consistently incorporate that into our security selection.  That’s also a, a very important point of differentiation in the sense that because we’re not relying on third-party data providers, because we’re not trying to solve for what the world thinks is best but we’re really focusing on what we think is important, the material factors that we think are important to ESG considerations.  You know, we’re coming up with our own assessment, and sometimes is agrees with the third-party data providers and sometimes it doesn’t.  But we see the benefit of making that assessment on our own, because we’ll ultimately really be educated about these factors from a holding-to-holding basis and can, and can compare those risks associated with these issues across all of our holdings.


Charles Roth:    Let’s talk about those holdings and, and how you identify those positions that make it into the portfolio, both the core EM as well as the dedicated EM ESG strategies are, are rather concentrated.  Roughly to 4 or 5 dozen stocks in each.  They’re diversified across sectors, geography and, and style factors.  But before we get into the diversification characteristics, what do all the companies in both strategies have in common?  Are, are there common characteristics that you’re looking for in all of your investments?


Charlie Wilson: Yeah, absolutely.  The, the basis for stock selection across all of our EM strategies is our focus on strong businesses.  So, if you step back for a second, emerging markets are a combination of tremendous opportunities:  so long-term opportunities in terms of demographic; the rise of the middle class; the shift from the economic drivers of global trade and picks as an investment, more towards domestic consumption.  That’s happening really rapidly right now and we expect it to accelerate over this decade.  But the, the financial markets and emerging markets are, are typically not mature, and there’s consistently political regulatory uncertainty which drives additional volatility in the financial markets.  And because in many cases there, there isn’t an institutional investor base that can step in and help to set prices during market dislocations, often stock prices will overshoot.  Our process is to identify around 400 companies across emerging markets which we think have a dominate position in their markets or value chains.  What that typically leads to is the ability to take price during periods of difficulty, which lead, usually leads to higher operating margins, higher returns, things that are consistent with quality.  But we’re not screening for quality in a quantitative sense.  We’re actually looking for these dominant business models in a qualitative sense.  And that’s why it requires an active judgment on our part, and so that’s the basis for stock selection across all of our strategies.  The second piece – and then that’s just, that’s an outcome based on our approach to investing in emerging markets of really trying to be confident of companies that may be caught up in periods of volatility, market dislocations like what we saw last year.  But they’re, they’re not only going to survive those periods of stress, but come out on the other side and thrive by perhaps by taking market share from weaker competitors.  The other enhancement I would say for the ESG strategy, is that we look for companies that fit that strong business criteria, but in addition have that positive externality which we think will lead to long-term out-performance of those companies.


Charles Roth:    Shifting to the portfolio construction process, and the core is quite different from the EM ESG portfolio construction process.  Can you walk us through the EM ESG strategy and how it, you, you construct the portfolio?


Charlie Wilson: Sure.  In the core portfolio just to give you a little background of how we construct that portfolio, so to, to juxtapose it versus the ESG strategy.  In the core portfolio we focus on three baskets; basic value, consistent earner, and emerging franchise.  The base value represents more of a, a value or cyclitol tilt.  Companies that would have that type of earnings, volatility or, or cyclicality in their cashflow streams.  And then consistent earners or steady compounders or steady growers that typically act as the ballast of the portfolio during downturns.  And then emerging franchises are more aggressive growth names that earlier in the lifecycle that haven’t quite reached that strong business status that we require of the other two baskets.  So, they tend to be more volatile so we, we keep them as a smaller part of the portfolio at less then 20 percent.  Whereas, the other two are closer to 40 percent of the portfolio each.  The goal of that portfolio construction is to have consistent performance driven by stock selection regardless of the market environment.  So what, regardless of whatever the style leadership is currently.  In the ESG strategy, we take a different approach to portfolio construction.  Our primary goal in the ESG strategy is to tie our companies to positive outcomes, and we use the UN Sustainable Development Goals as a framework to identify companies that are creating positive externalities related to those goals.  We use that as our compass, because frankly, you know, there’s a lot of, of different ways to frame doing good or generating a positive externality.  But in this situation, we feel like the UN Sustainable Development Goals represent a broad cross-section of views about the, the kinds of challenges that the world needs to solve going forward.  And that’s why we use it as a framework reference.  So then we have thematic baskets that are tied to those goals, and most of the baskets are actually related to, say, five to six Sustainable Development Goals of the 17 Sustainable Development Goals.  The outcome of the thematic baskets is that we tend to diversify the portfolio by business model and underlying business driver, which then leads us to a diversified portfolio.  We really didn’t want to create a portfolio that was too heavily weighted to a particular theme or sector, like you know having a large solar weight or, or renewable energy weight in the portfolio, or too much of a focus on microlending.  And that’s why we created this framework of, of five thematic baskets tied to the sustain, Sustainable Development Goals.


Charles Roth:    So just for our listeners, those five broad themes are:  Sustainable Consumption; Financial Inclusion; Digital Services and Technology; Health, Wellness and Education; and New Energy and Infrastructure.  So, it’s quite interesting.  You have the factor-based style of value, growth and emerging franchise as emerging growth.  And then you have these thematic baskets as, as well.  Is there any other sort of diversification mechanism that you integrate such that you can mitigate the volatility that is often higher in emerging markets?


Charlie Wilson: In all of our emerging market equity strategies, our focus is trying to mitigate the volatility where possible.  So, we frame it as multiple layers of risk management that are embedded in the investment process.  So the primary line of defense against volatility is the, the stock selection process, so the focus on strong businesses.  Those are the businesses that are likely to rebound fastest coming out of a downturn, and are more likely to, to gain share and, and have a stronger position coming out.  The portfolio construction process is an important part of that.  That’s very important for the core of developing world strategy.  Whereas, in the ESG strategy, we focus on the diversification of businesses across the thematic baskets.  The third line of defense that we talk about is our approach to currency risk management.  And so we’re bottom up, so we’re fundamentally driven and focus on stock selection, but we need to incorporate higher level, so macrolevel considerations into that process.  They’re 27 different countries in emerging markets and they all have different considerations, which could impact the currency or, and drive currency volatility.  We have identified a way to incorporate or macro or top-down considerations in a bottom-up framework in a consistent way across those markets by evaluating our expected long-term loss of value of a dollar-based investment in those local markets.  Basically, what’s the, looking at things like the inflation differential or, or fiscal deficits.  These things tend to persist for some time; 5, 10, 15, 20 years in some cases.  And so we can make a reasonable estimate of what our long-term loss in value on an annual basis will be.  And what we do is use that to raise the hurdle rate of our existing investments in those markets.  And in actual outcomes, we tend to steer away from markets with more volatility, more currency volatility, because that usually means longer term that there’s more loss in value from currency.  Unless we’re paid to take the risks and so, you know, more recently with rising concerns over the last couple of years about dollar appreciation I know that, that conversation has ebbed and flowed over time, but it’s generally been a focus on, on a stronger dollar over the last couple of years.  That’s been a, a headwind for emerging markets, but we found that, that’s pressured valuations in markets that tend to have currency volatility, and so we found some attractive opportunities there.  And the last piece is our ESG integration, which we think helps us to extend our perspective about, as I mentioned, the company’s utilization of resources which can ultimately help us to make a better assessment of the, the long-term value of the business.


Charles Roth:    Thank you for your time, Charlie, very interesting.


Charlie Wilson: Great, glad we could do it.


Charles Roth:    To find more on Thornburg’s ESG views and product offerings, please visit our website at Thornburg.com.  Today’s episode was produced and edited by Michael Nelson.  You can find us on Apple, Spotify, Google podcasts, or your favorite audio provider, or by visiting Thornburg.com/podcasts.  Subscribe, rate us, and leave a review.  And please join us next time on “Away from the Noise.”



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