Hey, what about the G?

These days it seems almost impossible to interest anyone in a fund that doesn’t tout its ESG credentials. ESG of course denotes environmental, social and governance considerations. Investors increasingly understand that unbridled shareholder maximizing capitalism often creates poor outcomes for society at large, which is not only ethically questionable but also runs tangible financial risk in the form of increased regulation, taxation and consumer boycotts of a company’s products.

The investment industry has been all too happy to oblige and offer the customer what they want. The problem is twofold. Firstly, our industry is quantitatively inclined and therefore tends to focus on what it can measure. The second issue is there is no such thing as a company with no negative externalities. 

Any business is a series of trade-offs between labour, shareholders, society at large, the environment and all the other stakeholders one can think of. Often classifying a company as ESG-compliant requires a rather blinkered view of the world. A solar panel requires lots of high-purity polysilicon which is manufactured at very high temperatures and is extremely carbon-intensive. A lithium ion battery, critical to electric vehicles, relies on the mining of cobalt and lithium, much of which comes from the Democratic Republic of the Congo, one of the poorest and most corrupt countries in the world.1 A shiny new smartphone is manufactured in factories with wage levels, working conditions and indeed rates of suicide that many Western customers would find unacceptable. 

However, because the brand owner rarely manufactures the polysilicon, mines the cobalt or assembles the phone themselves, these inconvenient facts about the supply chain are typically conveniently ignored in analyses of ESG. We are not arguing that any of these businesses are wholly unacceptable, rather that assessing a firm’s positive and negative impact is highly nuanced and hard to capture with purely quantitative metrics. 

By contrast, it is direct environmental impact that is most easily measured, and therefore what ESG tends to focus on. 

We spend our time meeting with companies in emerging economies. It doesn’t take too many trips to India, or Brazil, to realise what the biggest cause of social injustice is in these countries. It’s corruption. Corruption is one of the primary reasons why hundreds of millions of people live in extreme poverty, often within metres of a wealthy political and business class. 

This returns us to the title of our article, the oft forgotten ‘G’ in ESG, standing for governance. In the 30 years our team has been investing in emerging markets, the first question we ask ourselves is who owns the business we are seeking to assess? Very commonly, the entrepreneur or family in question made their fortune bribing their way to control a coveted state-owned asset or working their way into the good graces of corrupt politicians. Often this sort of information is easily uncovered, but ignored by the investment community because it is hard to measure quantitatively (do you inflation-adjust a bribe paid in 1990? does a bribe to a president get a higher score than a bribe to a mere telecoms minister?) and because it is deemed irrelevant to the exercise of predicting whether earnings will go up in the next twelve months. 

Our distinct approach leads us to reject a majority of potential investment opportunities in emerging markets, including many of the largest index constituents. We do this not just for ethical reasons, but also because we believe it helps avoid large investment risks, even if those risks are difficult to quantify and may not materialize for a long time. While an incumbent politician remains in power these risks may be almost zero, though when there is a regime change the consequences of building a franchise based on kickbacks to politicians can materialize very suddenly and dramatically. 

We choose not to use ESG screens to rule out potential investments – even though this would no doubt help us to sell funds – as we believe them to be blunt implements, relative to the nuances of assessing a complex business with all its strengths and weaknesses. By analogy, while we are highly valuation-conscious we would never screen-out companies that are valued at more than, say, 30x last year’s earnings (or P/E) because the ‘E’ in question is only a crude approximation of a firm’s long-term earnings power.

One of our favourite Brazilian companies (not currently owned in the global emerging market strategy), an energy generation firm, derives 80% of its generating capacity from ‘clean’ hydro, wind and solar, while the remaining capacity, just under 20%, comes from coal-fired power plants. Should we screen out this company on the basis that it uses coal, or recognize the healthy role it is playing in a transition to low-carbon electricity?

We also own two cement manufacturers in the strategy, which score poorly on some ESG scorecards because cement is one of the most carbon-intensive products in the world. However, in both cases the companies are investing in equipping their plants to run off lower-carbon fuels (natural gas and waste materials). The large majority of the cement they produce goes, not to big infrastructure projects like airports and high-end shopping malls that tend to line politicians’ pockets and benefit the wealthy, but is sold by the bag to families building sturdy homes that are often their primary vehicle for preserving their hard-earned savings. So, despite the environmental costs, there are also clear societal benefits. 

These are just a couple of examples of the competing considerations we have to weigh when assessing a potential investment and its risks. We often find that a risk-aware entrepreneur has inevitably thought carefully about the environmental and social impact of their business, whereas someone who has built an empire on graft is far more likely to believe they can make such problems go away with a bribe or a political donation. Hence our focus on the G can help us better understand the context of the E and the S. All three are useful lenses through which to assess the approach to risk and values of managers, which is the essence of our investment philosophy. 

Dominic St George
March 2021

The interactive map illustrates some of the different types of owners who provide strong governance for the largest holdings in our Latin America strategy. These owners or ‘stewards’ as we frequently refer to them, vary in nature, but all have demonstrated a high regard for minority stakeholders which, in several cases, can be dated back over multiple generations.

View our stewardship map

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Source for company information: Stewart Investors investment team and company data.

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