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ESG in Emerging Markets

As minority investors, this is essential to enable us to make informed decisions about the value of a company.

By having an understanding of a company's principle ESG issues ahead of investing, we can better understand not only how sustainable a business model is but also, what the major risk factors are.

A good example here would be the risk of disruption, perhaps best exemplified by the auto industry which is at the onset of transitioning to a more sustainable future. In 2020, "everything related to electric vehicles (EV)" seemed to have been given a boost in the stock market. While we have significantly reduced Kon-Tiki's exposure to the auto sector in recent years, we have increased exposure to electrification as a theme via our investments in copper mining companies – copper being essential for electrification – as well as EV battery producers.

ESG: a source of new ideas

By integrating ESG into our research, we have also found it to be a good source of new idea generation. Examples include portfolio companies Atlantic Sapphire with its sustainable protein production through land-based salmon farming, and Orbia, one of the leading companies within precision drip irrigation systems, with its focus on water retention.

An integrated research approach to ESG also helps us to assess the quality of management and their strategic positioning. Depending on the industry, it can, for example, give us a better understanding of branding opportunities, customer perception, product safety, culture, employee retention, incentives and benefits, etc. Overall, we believe an ESG focus helps us make better informed investment decisions, and provides us with a better safeguard against uncertainties.

EM versus DM

From an ESG perspective, there are several key differences between investing in emerging markets (EM) versus developed markets (DM). More mature markets with higher institutional ownership and more developed governance codes tend to be stronger at addressing agency risks for example. In EM, we commonly meet with dominant shareholders (often founders or state-owned enterprises) which means there is often a greater divergence between minority investor and majority owner interests.

The companies we invest in should, in general, have a structure that demonstrates stewardship of assets and value over time, as well as protection for minority shareholders. We seek to understand the decision makers, whether there are conflicting motives, how risk and reward are assessed and whether returns made on incremental capital fall back to us as shareholders. These are issues which can be difficult to judge without actively meeting the companies. We have found that company accessibility has improved greatly since the onset of COVID-19, helped by technology.       

Historically, reporting on ESG issues has been inferior in EM. There remains a lack of universal reporting standards, but we have seen great strides in improved transparency within many EM companies, particularly over the past couple of years, and this puts pressure on others to follow suit. Stock exchanges initially played an important role in encouraging clearer reporting and disclosures, but we believe investor attention is now pushing companies to improve standards.

Focus on engagement

We have intensified our focus on engagement over recent years, something that enables us to raise management awareness of how ESG factors can help shape a company's operations and thereby increase its valuation. In 2020, we engaged with companies directly on ESG matters in more than 10 unique cases. Our experience is that companies are increasingly willing to listen to long-term shareholders like us. In general, companies are very receptive when we engage with them on issues such as reporting standards, improving governance standards to industry/global best practice, connected transactions disclosure, potential conflicts of interest resolution, minority interest protection, shareholder return/balance sheet management, human rights practices, and feedback on the nature and quality of ESG disclosures. There seems to be a genuine interest, on a general level, to use informed and long-term investors as sounding boards for improved governance practice in EM. Our dedicated in-house ESG experts have been very helpful in our engagement work as this adds credibility to our process.

Sustainability is key to long-term investing

Academic research has proven that sustainability matters for long-term investing. The mainstream view in the past was that sustainability was something that restricts the ability to generate returns; the evidence now is that it enhances it. While we subscribe to external vendors for ESG updates and reports, we exercise our own judgement and make our own decisions about the sustainability of a business and its attractiveness. ESG consultants still appear too backwards looking and often focus on ticking boxes and assigning scores which do not necessarily reflect today's reality. Active management is therefore all the more important in EM where the improvement potential is greater within all E, S and G factors.

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