Sustainable Equities Boutique

ESG in emerging markets has room to mature

Emerging Markets

Roger Merz

Head of mtx Portfolio Management, Senior Portfolio Manager

As sustainability-minded equity investors are looking beyond their home turf, the global importance of environmental, social and governance (ESG) standards is rising. But while their significance is relatively high in the “west”, emerging-markets companies have some catching up to do, according to Lara Kesterton, Vontobel’s Head of mtx ESG Research.

“Emerging-market companies sometimes use their ESG reports as a marketing tool,” Kesterton said in a webinar. “It’s just as important to look at what’s missing,” she noted. Part of the problem is that ESG data from emerging economies is sometimes hard to come by. A deep dive into the matter requires a lot of experience, Kesterton added.

ESG associated with safety and quality

On the face of it, one might conclude investors interested in emerging-market equities gain only little from integrating ESG aspects in their decisions. Nor does an improving trend in ESG scores, so-called ESG momentum, help EM stocks, according to Kesterton. However, sustainability was found to support other valuable investment qualities. “ESG is positively correlated with safety – meaning lower volatility, higher stability and lower earnings risk,” she said. Moreover, good sustainability credentials act as a proxy for quality, Kesterton noted, adding that such companies tend to be better ESG performers.

However, Kesterton pointed out, these findings only speak to headline ESG scores, adding that ESG scoring in EM has room to mature and reflect local norms better to identify the channels of risk and opportunity more effectively. But it is important to remember, the real purpose of ESG is to form a robust view of a company’s ability to manage and withstand real-world risks over one, three, or five years. To do this, ESG scores and frameworks are just the starting point on a path to a multi-layered view from many sources. As EM companies are typically closer to the “coal face”, to use a mining term, investors and researchers can’t rely on headline ESG scores but need to do their own homework to evaluate companies’ risk exposure in the context of industry and regional norms, according to Kesterton.

Referencing sustainability studies with other outcomes, the ESG analyst noted that results can vary significantly by changing a few variables. “There can definitely be a danger of getting lost in the data,” she said. “There needs to be a balance between quantitative objectivity and rich qualitative understanding of sectors and regional trends to adequately capture the complexity of real world problems that ESG tries to address.”

Strong sustainability scores well in developed markets

Mtx’s own quantitative ESG research reflects a fundamental aspect of its longstanding data-driven investment approach that is, nevertheless, continually evolving. Looking at the ESG side of things, the team naturally wanted to explore for themselves the historical relation between sustainability and companies’ return on invested capital (ROIC), as well as performance, Roger Merz, Head of mtx Portfolio Management, said. While highlighting ESG as an integral part of the mtx team’s investment approach, Merz made it clear that he believes in the overriding benefit of top-notch ROIC, and also companies’ industry position and intrinsic value. The mtx study supported this, showing that the contribution of ROIC to active returns in emerging markets exceeded that of sustainability. An important finding for the boutique was, therefore, to apply fundamental company analysis first and add ESG as a secondary layer. And when focusing on tier-one ROIC companies, avoiding the worst-in-class ESG companies is clearly beneficial, Merz said. Mtx’s head of portfolio management also noted that the picture changes when looking at developed markets where a more consistent and linear relationship between ESG scores and performance is plain to see. There, a different approach to ESG thresholds may be more appropriate.

Growing interest in “green” emerging-market stocks

Despite ESG’s teething problems in emerging economies, sustainability will probably become an important factor there as well. “ESG in emerging markets is still young and evolving. We expect that ESG in emerging markets will become more significant over time and converge with the more consistent patterns we see in developed markets,” Merz said, adding that there will always be regional and national differences in ESG norms and trends. Still, sustainable investing looks set to establish itself in emerging economies for a number of reasons. As the numbers of environmentally conscious investors are swelling, companies hoping to attract international investors will need to improve disclosure quality and quantity. Broader analyst coverage as well as more nuanced ESG scoring systems will also help, Kesterton noted.

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