In emerging markets, ESG issues play an essential role. Even more so than in developed markets. Governance in particular is a factor to watch, as emerging countries have varying standards of governance, which can have a substantial impact on returns. Robeco has been incorporating sustainability in the analysis of emerging markets companies for over 15 years.
Having invested in emerging markets for more than 20 years, we have found that integrating ESG factors into the investment process is crucial. Market inefficiencies caused by lower standards of data availability, poor transparency and governance standards, and issues relating to climate change, human rights and product safety standards are a potential source of alpha for emerging markets investors.
We primarily focus on corporate governance. When there are fewer external institutions to protect minority shareholder interests, which is the case in many emerging markets, good governance becomes more important.
Besides corporate governance, environmental issues can also be material to emerging markets companies. We see climate change, for example, as both a business threat and an opportunity. Opportunities may be investments in renewable energy and in terms of threats, we may look at future capex adaptation requirements or even future asset impairment (such as stranded assets) which the market underappreciates. Social issues, such as labor issues at manufacturing companies, can also pose risks to companies’ sustainability and financial profitability and, ultimately, investment returns.
Emerging markets companies are increasingly striving to adopt developed market standards. They have to, if they want to expand their global market share to new markets.
Robeco’s Emerging Markets Equities team has been incorporating sustainability into its company analysis for over 15 years. Long before sustainability became part of mainstream investing, we recognized the importance of ESG factors, and started conducting our own proprietary ESG survey in 2001.
Currently, three pillars underpin our ESG effort:
ESG integration into country and stock selection research
ESG factors are integrated into both the top-down country allocation and the bottom-up stock selection process. Not all ESG information is relevant, though. In cooperation with RobecoSAM, our sister company dedicated to sustainability investing, we identify the ESG factors that are material to the companies covered. Material means that these factors can have a substantial impact on a company’s business model and value drivers such as sales growth.
Top-down country allocation: country risk premium
In our top-down country allocation, fundamental analysis is dominant. A key part of our fundamental analysis is comparing emerging markets’ economic, political and social strengths. This evaluation includes ESG issues such as a country's transparency, political stability and protection of shareholder rights. In addition to our proprietary ESG survey and RobecoSAM’s Country Sustainability Ranking, we use third-party data, such as the Corruption Perception Index or the International Country Risk Guide on political risk.
Analysis of the ESG factors can lead to a country risk premium in the valuation analysis of individual stocks. This implies that a country with a negative ESG profile will be penalized in its final valuation assessment.
Bottom-up stock selection: impact on the valuation analysis
In the bottom-up stock selection, ESG information is integrated into company analysis and can have an impact on company valuation. We believe that this enhances our ability to understand existing and potential risks and opportunities.
To determine a company’s ESG performance, we use our own ESG survey, which covers 1125 companies in emerging markets, including all of the MSCI Emerging Markets Index and other key emerging markets names, both large caps and small and midcaps. In addition we use RobecoSAM’s sustainability scores and external research from Glass Lewis and Sustainalytics.
We do not use ESG performance as a sole reason to buy or sell a stock, but if the risks and opportunities are significant, the ESG analysis will impact a stock’s fair value. We can, for example, augment the weighted average cost of capital (WACC) with 100 or 200bps. Other input factors such as sales growth or margins can also be impacted both positively or negatively. For example, if China were to instate a carbon tax, we would increase the operating cost of a coal-fired Independent Power Producer.
We maintain an active dialogue with companies and vote at shareholders meetings, cooperating with Robeco’s Governance and Active Ownership team. We are in close contact with them to discuss topics such as the appointment of board members or the availability of financial statements before the proxy voting deadline passes.
Finally, we apply an exclusion list, but mainly as a last resort. As a rule, we exclude the following companies, in line with Robeco’s exclusion policy:
When companies do not engage with us or do not change their stance after extensive discussions, we may decide to exclude them. Still, as long as the dialogue is open and making progress, we prefer not to exclude companies, as that also means that we cannot exert influence on them anymore.
Market inefficiencies caused by ESG factors are a potential source of alpha. Integrating ESG data into our country and stock analysis allows us to determine the true value of an investment opportunity. These data carry a significant weight in our investment process. They impacted a stock’s fair value, and therefore its weight in the portfolio, in approximately 30% of all investment cases and stock updates conducted last year.