InvestmentsMay 11 2015

The ESG effect on frontier equities

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Ask the average money manager for an honest view of environmental, social and governance (ESG) issues and it elicits one of two responses.

In the first camp, you’ll hear that these are niche markets for investors willing to sacrifice financial returns for ethical considerations; it’s hippy stuff with no interest or value for hard-headed investing.

Alternatively, they will acknowledge a trend from some underlying investors – Norway’s $860bn (£565.6bn) sovereign wealth fund has been the most high-profile example, having divested from 49 companies over the past 12 months because of ESG issues.

But these managers are missing a trick. ESG factors offer an alternative, and currently under-considered, insight into the behaviours and standards of companies that can pragmatically benefit investment decisions by providing a forward-looking indicator of returns.

This is of particular significance in frontier and emerging markets, where the means for active managers to achieve a consistently informed, and therefore competitive, advantage are often limited.

The example of South African platinum miner Lonmin is instructive. Many funds and exchange-traded funds (ETFs) with exposure to South Africa will have had the company in their portfolios. It is, after all, a large company in a large, investable industry.

However, those analysing Lonmin’s ESG credentials would have been aware of the company’s strained relationship with its workforce. Among the issues were poor working conditions and a demand for better wages from employees.

Through August and September in 2012, 44 workers were shot during labour protests at Lonmin’s Marikana mine. Like many failures in ESG governance, the tragedy was entirely a human one, but with a profound economic effect.

Likewise, it has been well documented since the Gulf of Mexico accident that BP’s health and safety record was among the worst in the industry.

However, an ESG-led approach is not limited to the consideration of standards. Momentum and improvement in a company’s approach to ESG will also lead to returns for stakeholders. In this sense, ESG is not just a means of reducing volatility but also about value creation.

Consider the Indian pharmaceutical company Glenmark. For a long period, its management had very aggressive accounting policies for research and development (R&D) – it was all capitalised on the balance sheet and not expensed. The market woke up to this and the share price collapsed.

Fortunately, management realised that to generate value it could no longer shoot for quick profit and loss (P&L) fixes, but needed to align its interests with those of external investors.

The result was an evolution to the most conservative reporting standards of the peer group. Accounting policies now reflect R&D going through the P&L, sensible assumptions on depreciation and a strong anti-bribery stance. Glenmark’s share price has responded in kind.

Another example is provided by Grupo Nutresa, a Colombian food and holding company previously known as Grupo Nacional de Chocolates. During the 1990s the firm operated a very complex structure, with lots of subsidiaries and cross-shareholdings – in short, it was a conglomerate mess. Management attention was focused on fending off takeovers as opposed to creating shareholder value.

It then began simplifying its corporate structure, selling non-core assets and focusing on capital allocation, resulting in improved shareholder value. The firm also laid out a vision to become the leading firm focusing on nutritional value for its customers.

The firm has since received a number of high-profile sustainability awards, and is one of only six Latin American firms currently in the Dow Jones Sustainability index. From not focusing on ESG values 15 years ago to those values being a core part of the company’s make-up today, it has generated value for all its stakeholders.

So how can you formalise these observations into a monetisable strategy?

Firstly, ESG must be fully integrated into the investment process – not a peripheral screening but a fundamental way of thinking. It should be forward-looking, understanding where a firm is going, not just where it has been. In turn, managers need to show strategic engagement, pushing for change with company management.

At the end of the day, investors should embrace ethics – because it might just make them money.

Chris Wehbé is global markets strategist at Alquity