EM equities: assessing sustainability – kicking tyres, not ticking boxes

Written By: Ian Tabberer Portfolio Manager, Janus Henderson Global Emerging Market Equities Janus Henderson Investors

Ian Tabberer at Janus Henderson Investors outlines why he believes the creation of long-term investment returns is, by its very nature, investing in sustainability

Investment returns and environmental, social and governance (ESG) concerns are not separate entities – they are intertwined. A company that abuses its customers, dumps toxic waste in a river or has questionable governance is providing a warning sign that it does not care about the long-term future of its business. That should ultimately be reflected in its valuation and long-term return potential. A business that simply seeks to improve its returns in the short term is likely to be caught out when customers, or the government, respond to these abuses. This is why following the industry trend of placing an ESG title on a strategy may not be the best approach.

Assessing sustainability
While the history of investing with a view to influencing societal change spans many decades, arguably, the term “ESG investing” was first devised in 2005 in a landmark report called “Who Cares Wins”. It was initiated by a former UN Secretary General as part of the UN Global Compact in collaboration with the International Finance Partnership and the Swiss government. Since that time, attitudes towards the provision of ESG-related information by companies have changed dramatically.

As reported by Forbes, 80% of the world’s largest corporations use Global Reporting Initiative (GRI) standards. Emerging Market companies were initially seen to be lagging in this regard, but standards have improved. The need for developing economies to attract equity capital has seen stock exchanges that set the tone for corporate governance and reporting. The natural human response to this avalanche of ESG data is to quantify, simplify and compare. This can be seen through the numerous providers of standardised ESG metrics, utilising “big data” to crunch the numbers. While useful in part, our preference when assessing sustainability is to focus less on the “what” and more on the “why”. The disclosure of a policy or quantitative metrics will not necessarily reduce risk, unless the governance structure and culture of the institution are aligned. Policies are easy to disclose, but difficult to embrace.

Just because something can be measured does not mean it provides a valuable signal
The problems associated with a data-centric approach to assessing sustainability factors can be seen in Russia. We do not currently have any Russian companies on our proprietary watch list as we cannot currently find businesses of sufficient quality. The kleptocratic business environment also poses significant challenges to minority investors. A casual reading of Bill Browder’s book Red Notice gives legitimacy to the notion that minority investors may not receive significant protection from the Russian judicial system.

With this in mind, one may therefore be surprised that in the World Bank’s Doing Business Rankings – 2018 report, Russia ranks 35th, immediately below the Netherlands, Switzerland and Japan, in that order. That is because the annual ranking of business friendliness of regulatory systems is not based on a qualitative assessment of business surveys. It analyses regulations and regulatory change, awarding points for pro-business measures and deducting them for anti-business practices. As the Financial Times acknowledged in 2015 when commenting on that year’s report, “in many ways it favours authoritarian regimes with the capacity to pass regulations quickly through rubber-stamp parliaments over democratically elected ones. It also appears to put a premium on laws as they are written rather than how they are enforced.”¹ It is a good example of the risks associated with putting significant faith in a score-based system of evaluation.

“Greenwashing”
The limitations and risks of assessing sustainability using a purely data centric and scoring based system can also be seen with the ESG ratings industry. More data can help improve transparency and the evaluation of these risks. It can also allow poor management teams to hide behind a wall of data. Some high scores may reflect a company’s marketing programme and disclosure efforts rather than its true commitment to ESG and sustainability. Greenwashing refers to a company or organisation that spends more time and money claiming to be “green” through advertising, marketing or disclosures, than actually implementing business practices to minimise negative ESG impact. It is the embodiment of Goodhart’s law – “when a measure becomes a target, it ceases to be a good measure”.

The value of engagement
Corporate owners and management teams should practise what they preach; investors should look beyond the glossy sustainability report and discuss with the leaders of a business how they view their specific sustainability challenges. Good management teams should continually assess the threats that their businesses face – be it competitive, industry, societal or environmental. In doing so, it leads to a different style of interaction with management. It also helps to build relationships as they understand that our interests are broader than simply trading paper.

One approach would be for investors to engage with a company to discuss matters such as their strategy, capital management and board composition, to remuneration, environmental impact and reputational risk. These kinds of engagement can often help to build conviction in the broader investment case. In addition to ensuring a company has a good record of corporate governance, understanding the company’s community relations and approach to environmental challenges is also extremely important. The market tends to underestimate how often these types of non-financial risks become real financial losses, particularly within emerging economies with immature legal and political systems.

Active listening
Directing capital towards productive and responsible investments brings with it a responsibility to engage, enquire and influence where necessary. Active listening is an important way to bring about change and high quality management teams are naturally incentivised to lead businesses in the right direction over the long term.

We believe that the distinction between ESG and investment philosophy and process is an arbitrary one. Ultimately, all of these factors feed into the consideration of the quality of a business, and the sustainability of a forward-looking basis for its franchise. To that end, it should not be a surprise that we follow the same approach to assessing sustainability as we do when looking at other aspects of a business. We prefer to “kick the tyres”, rather than “ticking boxes”. The creation of long-term investment returns is, by its nature, investing in sustainability.

Important Information
This document is intended solely for the use of professionals, defined as Eligible Counterparties or Professional Clients, and is not for general public distribution. Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and investors may not get back the amount originally invested. There is no assurance the stated objective(s) will be met. Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell, purchase or hold any investment.

There is no assurance that the investment process will consistently lead to successful investing. Any risk management process discussed includes an effort to monitor and manage risk which should not be confused with and does not imply low risk or the ability to control certain risk factors. Various account minimums or other eligibility qualifications apply depending on the investment strategy, vehicle or investor jurisdiction.

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1. The Financial Times, October 27, 2015