Analyzing companies’ behavior when it comes to the environment, social issues, and governance (commonly known as “ESG”) has become more commonplace for investors. But some firms need more attention than others—especially those in smaller frontier countries.
Companies in frontier markets (the rising emerging markets) can be challenging to research.
Off-the-shelf information can be scarce, nonexistent, and sometimes even inaccurate. Mastering these markets means spending a great deal of time in each country, personally interacting with and vetting company management—and a research focus on ESG issues can be critical to investing success.
All in the Family
In early stage countries, capital tends to be controlled by fewer institutions—and, in many cases, individual families—who end up playing an outsized role in the economy. Given this backdrop, ESG serves as a vital tool for active managers. Governance becomes a filter through which investors can engage all stakeholders to determine where alignment exists and where it’s at risk. For instance, in companies with a controlling interest by a large family, investors need to make sure the asset is material, not a secondary part of the family’s portfolio. Investors should also determine whether other family-owned entities sell goods or assets to the public company.
The search for alignment doesn’t just apply to family-controlled enterprises—it also applies to governments. To be successful, investors must avoid getting in the way of a governing party’s objective, despite the potential ESG impact. If a government’s stated objective is to grow jobs by keeping electricity prices low, it makes sense to avoid an investment in an electric utility, for example.
Is ESG a Proxy for Best-in-Class?
In frontier markets, ESG practices may offer insights into companies more broadly. Does management seem to appreciate environmental risks and the importance of fair labor? Is there a governance structure in place to incentivize high quality outcomes? These can be signs of a well-managed company.
It can also point to a larger strategic vision. Focusing on the environmental, social, and governance issues can help investors understand whether management teams are committed to the long-term health of the business. Through their ESG research, investors can gain a greater comfort level that, even as minority shareholders, they have some lasting protection.
Consider an industry like cement, where the quality of management teams tends to vary widely. A good team can provide data on particle emissions, for example. And favoring cement companies that have the best environmental programs sends a clear message to those that are not as forthright. It sets the standard for information release that investors would require in order to feel comfortable taking a stake in the enterprise.
ESG Research Can Boost the Bottom Line
Frontier markets require an additional level of due diligence, and ESG can play a crucial role—one that appears to pay off. According to a recent study by Cambridge Associates, taking environmental, social, and governance considerations into account aided stock selection in emerging markets equities. In the five-year period since its launch, the MSCI EM ESG Index outperformed the broad EM market index by a cumulative 17.6% on a total return basis (Display). It seems that when it comes to investing at the frontier, ESG may represent the leading edge.
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The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.