DOES ESG DRIVE ALPHA IN EMERGING MARKETS?
We have always contended that investing in a portfolio of companies in emerging markets that rate well on Environmental, Social and Governance (ESG) factors need not result in a sacrifice of returns. Our research points to evidence that it can lead to superior returns and that there are intuitive explanations for this.
Sustainability (ESG) is a macro-thematic trend that is reshaping the competitive landscape, and companies that are able to respond to this trend and innovate early on will reap the benefits of stronger growth prospects, enhanced operating efficiencies, stronger social licence to operate, enhanced staff retention, lower cost of capital and, ultimately, a stronger and more sustainable competitive advantage.
They will also reduce operational risk and be positioned towards more sustainable growth, ensuring improved financial performance, which will ultimately have a positive impact on valuations and share price returns.
Our hypothesis is that better-rated ESG companies in emerging markets outperform the lower-rated ESG companies, as well as the benchmark, and therefore incorporating ESG factors when investing in emerging market equities can lead to superior returns.
To test our hypothesis, we compared the returns of the MSCI Emerging Markets Index constituents, grouped according to their ESG ratings.
We decided to apply the MSCI ESG Intangible Value Assessment (IVA) Industry Adjusted score to the MSCI Emerging Markets Index constituents from 31 January 2013 to 31 May 2017. We used this assessment tool and period since we believe that the MSCI’s IVA ESG score is a very reliable, independent and objective assessment, and to ensure sufficient coverage.
At 31 January 2013, MSCI had 80% coverage (90% by market cap weight) of the MSCI Emerging Markets Index, increasing to 99.83% by May 2017. The score is derived by analysing companies’ risks and opportunities that arose from ESG factors. Through an in-depth examination of material issues for the industry and rigorous benchmarking against industry peers, the MSCI IVA ESG score can reveal hidden risks or opportunities that may not be captured by conventional financial analysis.
ESG INTANGIBLE VALUE ASSESSMENT (IVA) APPLIES A THREE-STAGE APPROACH:
- STEP 1: Identify key ESG drivers of risks and opportunities for each industry
- STEP 2: Evaluate risk exposure and management
- STEP 3: Rank and rate each company against industry peers
The companies in the MSCI Emerging Markets Index were ranked and placed into five portfolios according to their MSCI IVA score: Portfolio 1 (8-10); Portfolio 2 (6-8); Portfolio 3 (4-6); Portfolio 4 (2-4); and Portfolio 5 (0-2). We equal-weighted each portfolio at the start of the analysis, without rebalancing, to allow for price movement in order to see how each portfolio would perform if we held on to the same basket of companies for the duration of the investment period.
JUST A “GOOD TIMES” SIGNAL?
These quantitative research findings provided compelling support for our hypothesis. We were, however, concerned that it might have been a “good time” signal that would only add value in bull markets. To test whether ESG factors provide alpha in both bull and bear market conditions, we decided to test two extreme sectoral performances over the same time period.
During the period under assessment, the information technology sector showed significant outperformance whereas the energy sector underperformed. The same methodology was applied to both sectors for the same period. And even though the information technology sector as a whole performed well at 53.6%, the companies in Portfolio 1 significantly outperformed their lower ESG scoring peers in Portfolios 2 to 5. Portfolio 1 with 84.5% outperformed the Infotech sector by 30.9%.
The energy sector, as mentioned above, experienced a negative return of 19.1% during the assessment period. However, we can see from Graph 3 below that even in bear market conditions, the better-rated ESG companies continued to show positive performance. Portfolio 2 significantly outperformed Portfolios 3 to 5, as well as the energy sector as a whole by 32.2%.
GOVERNANCE IS A KEY PILLAR
Ensuring that the companies we invest in meet our minimum corporate governance requirements is a key pillar (alongside quality and valuation) of Old Mutual Global Emerging Markets boutique’s investment philosophy.
To evidence this approach, we provide some detail below on one of the holdings in the Old Mutual Global Emerging Markets Fund, Taiwan Semiconductor Manufacturing Company Limited (TSMC).
TSMC is the world’s largest semiconductor foundry, representing around 30% of global capacity. It manufactures leading edge chipsets for nearly all of the global leading electronics companies, including all of Apple’s upcoming A11 application processing units for the new iPhone, to be launched in late 2017.
TSMC has been a core holding in the Old Mutual Global Emerging Markets Fund since 2012. It has a very strong competitive advantage through scale, technology, leadership and customer trust and is the leader in an industry with high barriers to entry (due to technology, very high capex and R&D requirements). It also has a highly regarded, experienced and educated management team. TSMC has sustained returns on invested capital at above 25%, with a free cash flow margin that has averaged more than 20% over the past 10 years.
TSMC rated very well in the internal proprietary framework that we use to analyse the governance structures, policies and practices of all companies we consider investing in, scoring 81% against our hurdle rate of 60%.
TSMC also scored very well on the independent, quantitatively-based assessment that was developed by the Responsible Investment team, scoring 5.7, which is much higher than the MSCI Emerging Markets Index average of 4.9.
At 31 January 2013 TSMC was a constituent of Portfolio 2 in the above analysis. By 31 May 2017 it had improved and would have been eligible to move into Portfolio 1 had we run the split at that time. TSMC delivered a total shareholder of return of 121% in US$ from 31 January 2013 to 31 May 2017.