Finding Sustainable Winners in Emerging Markets

    Sustainable investors are often known to shy away from emerging markets. And who could blame them, given the developing world’s heavy reliance on fossil fuels, mining, and carbon-intensive industry, further exacerbated by geopolitical issues, poor corporate governance, and lack of transparency?

    Jack Nelson, the lead manager of the Global Emerging Markets Sustainability strategies at Stewart Investors, begs to differ. He points out that sustainable investors have an essential role to play in emerging markets, as that is where the most pressing issues we need to address today reside. “Total global emissions depend more than anything else on the energy mix in China and India. Deforestation is a Brazilian and Indonesian issue, driven by the demand for agricultural goods from emerging Asia. Further, the societies that are most dependent on a changing planet and have the least resources and institutional ability to adapt and mitigate are all developing countries,” he says.

    Starting from zero, not from an index

    Admittedly, looking at the top ten holdings of an emerging market index might dishearten any sustainably minded investor. Chinese banks and Brazilian mining companies, even when underweighted in a portfolio, hardly make for an attractive ESG proposition. “But that is not how I want to invest,” reverts Nelson. “There are twenty thousand emerging market companies out there. Surely it should be easy to find forty or fifty sustainable ones,” he says. The trick is, according to him, to start with a blank sheet of paper, and instead of pruning down twenty thousand companies to fifty, to start from zero and build the portfolio up.

    Stewart Investors’ emphasis on long-term sustainability positioning does help to narrow down the investable universe to a manageable size. “We have a strong focus on seeking out those companies which support and profit from the ongoing transition to a genuinely sustainable future,” explains Nelson. “In simple terms, this means human development within the ecological limits of our planet. This is where we focus. Companies immediately stand out for providing sustainable goods and services, responsible finance or required infrastructure.”

    No need for trade-offs

    It is not hard for a bottom-up investor to find exciting opportunities in emerging markets, claims Nelson. “In fact, many home-grown emerging markets companies are tackling climate change and social problems with innovative and promising solutions,” he asserts. According to him, investing in such companies should, logically, lead to superior long-term returns, too. He is convinced that the companies benefiting from a shift to a more sustainable development path will experience greater growth tailwinds and face fewer risks than those threatened by such a shift.

    Apart from dismissing the idea of a trade-off between sustainability and financial returns, Nelson does not believe in having to compromise on environmental goals in the name of social progress either. “To me, the notion that the developing world should get rich first and then go green doesn’t make sense,” he says. “Providing the farmers of India and Africa with electricity tomorrow using coal-fired power generation would result in immediate gains in living standards. However, within a decade, all those gains would be erased as climate change makes their farms untenable and destroys the livelihoods on which those social gains depend.” The planet cannot afford for emerging markets to follow the same development path as the wealthy countries of today, according to Nelson. “No, India and Africa will have to shift towards renewables at a much earlier stage of their development,” he says.

    No shortcuts for emerging market investors

    For an active emerging markets investor, such rapid growth creates opportunities to find businesses that should thrive as they contribute to and benefit from sustainable development. It means, however, looking beyond ratings and scores and doing your own homework. “There are no shortcuts for an active investor,” says Nelson. “ESG scores can be pretty arbitrary, and ratings are riddled with methodological problems. It doesn’t make sense to me that a company like PepsiCo gets a high sustainability rating just because they are good at disclosing information and ticking all the right boxes. The product they sell and the way they package it is still unsustainable.”

    For Nelson and his colleagues at Stewart Investors, it is all about kicking the tires, getting out there and trying to understand a company’s business model, products and services, the environment it operates in and the country’s idiosyncrasies. “When a company in India appoints an independent female director, the rating agencies might get excited, dishing out points both for gender diversity and governance. We like to dig deeper and examine the fact that this particular director happens to be married to a minister in Modi’s government, for instance,” he explains.

    It takes time, and teamwork

    “We’d rather go deep and narrow than broad,” says Nelson. “We don’t need to understand every company, just to know a lot about a select few.” It helps, of course, that the team can lean on an enormous legacy of proprietary data and know-how collected over three decades. “We try to add to this body of knowledge,” he adds.

    Nelson sounds rather proud of his colleagues and the way the team works together. “We come from a wide variety of backgrounds and have a broad range of career and educational experience, from economics and civil engineering to international relations and languages. We all work as analysts, with no specific sector or country specialisation and no allocated watch lists of companies. Rather, each of us generates investment ideas according to our own interests and participates in all aspects of the investment process, including research, analysis, engagement, monitoring and voting decisions.”

    The art of engaging collaboratively

    As active owners, Stewart Investors seek to build relationships around a shared objective of improving a company’s quality and sustainability positioning for the long-term benefit of all stakeholders, explains Nelson. “I have noticed that if we push too hard, we get a lot of push-backs,” he says. “Engaging with companies in emerging markets needs to be personal and collaborative, private but persistent. What we try to do is persuade management by showing them the benefits of improving sustainability.”

    “Our role as active investors is to point out the issues and give the company space to address them,” says the manager. To exemplify this approach, he tells us about engaging with Indian companies on plastic pollution. In the country, many family hygiene articles are sold in small, single-use containers. There is a reason for it, of course, as many families cannot afford to buy a whole bottle of shampoo. Yet the plastic waste the practice generates is obvious to anyone visiting the country. Post-consumer waste collection is one solution, but without regional bans on single-use plastics, the problem persists. And so should the engagement efforts of investors.

    “We don’t take a decision to withdraw investment lightly, comments Nelson. “If we were to consider selling our shares every time a business faced challenges, we could hardly expect others to take us seriously as long-term investors.”

    It would appear that investing sustainably in emerging markets is not impossible, just hard. To truly understand a company, it requires venturing beyond ESG rankings and ratings and glossy sustainability reports. “This type of understanding only comes with meaningful conversations,” concludes Nelson.

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