Investors are increasingly scrutinised on companies held in their portfolios. In contrast to more traditional questions about growth and profitability, concerns are being raised about Environmental, Social and Governance (ESG) risks. Whilst we maintain a focus on sustainable growth in earnings and profitability, at an appropriate valuation, ESG analysis has become more integral with this. ESG considerations have been a part of Aubrey’s investment process since the firm’s inception, and over the last couple of years we have incorporated UN PRI principles into this analysis. We spend time engaging with company managements on material ESG risks that could impact long term company value. In other words, our ESG policy has led to a more active form of ownership where our aim is to encourage best practice, without compromising the potential for shareholder returns.
When evaluating companies on environmental factors, we assess a company’s efforts to actively lower its environmental impact. Lojas Renner, the largest fashion retailer in Brazil, is a leading example of this in our Global Emerging Market portfolio. Management has committed to a 20% reduction in absolute carbon dioxide emissions by 2021. 75% of the group’s energy will be from renewable energy sources. These efforts have been recognised with the award of the Gold Seal of Approval by the Brazilian Greenhouse Gas Protocol, a government body.
While some shareholders may look at these environmental goals and milestones as insignificant, financial value should be created for shareholders in the form of margin expansion. As a result of the increased use of renewable energy, management is expecting financial savings for the stores of around 13% to 26% a year. Lojas Renner demonstrates that sustainable environmental practices can contribute to increased profits, rather than be a cost to the business.
The theme of investors becoming less concerned about their portfolio’s asset allocation and instead more focused on social contribution also raises a question about a balance between profitability and social outcomes.
Yihai, a leading condiment manufacture in China targeting the Chinese hot pot market, demonstrates how staff welfare and profitability can operate hand in hand. Management is planning the expansion of its business overseas and the gradual transfer of some production to factories where labour is considered cheaper. While profitability may appear to be the sole objective for this strategic decision, management has implemented flexible working along with other welfare benefits such as childcare allowances and housing subsidies in China as an incentive to workers.
Given the nature of the industry, labour turnover will vary year on year, but these policies are a clear step by management to reduce staff losses. In this way, it is hoped that the company can expand overseas, improve employee retention in China, but without impacting margins.
The final component of Aubrey’s Global Emerging Market ESG analysis is corporate governance. The impact of an ethical outlook on managerial effectiveness is hard to measure but we look to invest in companies where management values are aligned to what is considered best practice and will ultimately be in the best interest of shareholders.
Apollo Hospitals, India’s leading health services provider, has recently appointed Deloitte as group auditor in place of a local auditor which had served the company for over ten years. We believe this is a move towards best practice, since not rotating an auditor after so many years of service may suggest that management has a relationship with the auditor that could allow potentially fraudulent activity to go unchecked.
We have developed a comprehensive ESG infrastructure and are pleased that these efforts are recognised within the Industry. John Ewart, co-portfolio manager of Aubrey’s Global Emerging Markets Strategy, and investment analyst, Jay Younger, were recently asked for input by a South African consumer goods company on how to incentivise management, specifically focusing on the key performance indicators within the company’s long term incentive plan.
The discussion centred around using a return based measure such as return on capital employed (ROCE) and comparing it to the company’s cost of capital. If the company’s ROCE is greater than the cost of capital, it demonstrates there has been value created by management. However, determining the cost of capital can often be subjective due to difficulties in the determining the risk free rate in emerging markets. As such, assessing how effective management has been when executing a strategy is not entirely straightforward unless a specific hurdle rate is set as a proxy for cost of capital.
An alternative metric that we proposed to reduce this subjectivity was free cash flow (FCF) yield. This can help measure the value management has created. If the FCF yield is greater than a hurdle yield specified in advance or the FCF yield has grown year on year, an investor can be confident that management is growing the business profitably.
Overall, Aubrey’s Global Emerging Market ESG process is pragmatic and focused. We do not exclude companies that have limited ESG disclosure, rather, we engage with management on material risks to encourage an improvement in ESG performance and disclosure over time. The Aubrey focus will continue to be identifying companies that fulfil our investment criteria, but we believe that a willingness to engage and act on ESG issues is no longer an option for companies.
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