Transcript: Emerging Markets and ESG: Challenges and Opportunities

Air Date: June 13, 2022 | 12:00 PM, EDT

Caroline: Good afternoon, everyone, and thanks for joining us. I’d like to welcome you to this week’s Monday Minute Live Chat hosted by the Canadian Leadership Congress. Today we’re talking about Emerging Markets and ESG, challenges and Opportunities. Here to address this topic I have with me today Susan Gim, who’s an investment client portfolio manager in emerging markets with Martin Currie, a Franklin Templeton company. Welcome, Susan.

Susan Gim: Thank you so much, Caroline. I’m really excited.

Caroline: Great. I want to start out by looking at ESG integration in general. A lot of asset owners, especially here in Canada, are very focused on this. When you talk to asset owners, what kinds of challenges do you see them running up against when it comes to emerging markets?

Susan: The first key thing, Caroline, is that there are a lot of geographies and companies in emerging markets. Over 1,200 names, 27 countries—it’s a lot of territory to cover, with each country and company within each country having its unique attributes in their ESG story. We’re talking about a really broad landscape.

I think embedded within that broad landscape is, obviously, secondly, the political element, right? The fact that these political systems really impact these companies and stocks on a fundamental basis, and also on an ESG basis. Specifically, we think the G. When you look at the ESG, the G is really important in emerging markets. Governance is where you spend a lot of time when you’re looking at ESG analysis for emerging market stocks.

Finally, I think this is a market where we’re really talking about those United Nations Sustainability Development Goals, UNSDGs. Here’s a fun anecdotal story. I’m a Korean American. I used to go to Korea as a child in the summers in [the] 1980s. Back then, the per capita GDP in Korea was $3,500. That was the average income of a Korean in 1987. Today, that per capita GDP [is] $32,000. In just one generation, you’ve had such tremendous changes in income opportunities and development. When we do actually think about the really big picture about development in emerging markets, it has a lot of very important things we talk about from a really big-picture level as well.

Caroline: Okay. You mentioned UN Sustainability Goals. They cover a pretty broad spectrum of environmental and societal challenges, as well as governance. What about data? You’ve talked about governance, but if you are trying to reconcile your emerging markets holdings and emerging markets approach with, say, the UN Sustainability Goals, where are you going to find the data to more broadly align those investments with your portfolio?

Susan: Yes, here’s an interesting thing - we find a lot of really good data at the company-level basis. When we think about some of these huge bellwether emerging market stocks, like a TSMC or a Samsung Electronics, what people don’t often realize is what a meaningful part of the workforce are women. Women and gender employment, development, women’s work cover four of those 17 UNSDGs. When we do this kind of work in the stock level, we can really learn that, for example, 80% of the technicians that work in TSMC’s factories are women, 53% of Samsung’s manufacturing head count, 60% of AIA’s employees, [and] 36% of the Alibaba partnership.

There is some really good progress emerging market companies have made when we think about some of these concrete data points like women’s work. When we think about other areas that we track from a big-picture-level basis, like data, the data on full representation is not great in North Asian markets, specifically. The micro looks good, but sometimes the macro is where we really need to work. For example, women hold around 15% of corporate board seats, potentially, in Asia. You compare that number in Europe; that number is going to be 38%. In the U.S., it would be 27%. There’s definitely a lot more work when it comes to some other elements of measuring ESG progress.

Caroline: Great. That’s a good thing to keep in mind. When you look at country risk, if we’re talking macroeconomically, how do you reconcile some of the risks you’ve identified or the characteristics you’ve identified around some of these countries with, say, a thematic or sector-based approach? Like resources, for example. How do you pull that apart in an emerging markets context?

Susan: I think it really makes sense to benchmark these companies within their sector. Really thinking about…for example, if I’m looking at a metals and mining company, what is their usage of natural resources? For example, what is their water policy going to be? Furthermore, benchmarking a copper mine against another copper mine in terms of their approach to their workforce and labour relations. We think that sector-specific analysis really can highlight outstanding companies that are doing really good work when it comes to the different attributes of ESG.

Then, furthermore, what’s really important for mitigating political risk is understanding the governance strengths of a company, and that is gained through really having constant engagement and constant conversations with the management teams [with] regard to some of the key issues around governance. What we mean by governance, specifically for a company in emerging markets, are things like who owns the stock; who controls the stock; who controls the management of the company; who controls capital allocation, CapEx; how is the management incentivized; what are the benchmarks used; what does the information disclosure look like for all of these governance attributes? We think doing that type of detailed conversation with management teams can really help and highlight companies that are doing best-of-class governance work.

Caroline: Now, do you find that working to engage with some of these companies, say, around governance, varies from region to region or country to country, depending on what you’re looking at in emerging markets? How do you approach that?

Susan: With different companies there’s going to be a key engagement focus that’s going to be different based upon its unique experience and its unique exposure set. Something that we spend a lot of time on with, for example, some investments in Taiwan, would be about water scarcity and the usage of water, because what you realize is that water is a tremendous resource for the utilization of semiconductor factories. They need a huge amount of pristine water. Water scarcity in Taiwan has actually been an issue that has been persistent for the last few years. Some of these key engagements will really be about business-critical attributes that are linked to ESG.

Caroline: Okay. Let’s look more broadly at that region and let’s look at China. China on the geopolitical stage, in certainly the last few years and certainly the last couple of months, has been a bit challenging. What’s your view on investing in China with a sustainable lens, especially now? Is it harder to do?

Susan: Yes, what’s interesting about China is that there really is a broad array of companies to invest in. There are many access points for investing in China. I would say the two key areas that most people tend to focus on in China are companies that are owned by the government, state-owned enterprises, or more private enterprise companies. Private enterprise companies in China have been some of the most entrepreneurial, with the highest return on equities often generating superior return on equities. They tend to be in industries that are not traditional; they’re more in neweconomy industries.

Those are some of the attributes where we think there’s interesting fertile ground for investing in China, is mainly on the private side, higher-return companies, more entrepreneurial management that has its own destiny in terms of strategy and leadership. I would say that’s the first key descriptor of Chinese opportunity sets.

The second key descriptor is really about these opportunities in which there really is this global impetus. These are sectors where China actually does have some significant leadership. These are sectors, for example, [like] electric vehicle batteries.

One thing people sometimes don’t know is that 30% to 40% of the purchase of an electric vehicle is actually the battery itself. China dominates in the manufacturing of electric vehicle batteries. This is one example of a sector that really does align to renewables, that does move away from combustion engines in which companies in China do have a global leadership position. I think what’s really interesting is that you really can find companies that align sustainability investments in China on the second part. I think the final part really comes down to understanding opportunities for leadership within the region.

It’s really thinking about not just leadership globally, but also potential leadership within China. I think a lot of the new economy, digital-economy companies in China just had such a tremendous impact on the daily consumer in China. For example, when we think about Tencent and their gaming business, there are anecdotal estimates that…like 60% of Chinese gamers are spending their time on a Tencent title. These are some very meaningful slices of your daily pie that these companies really do drive, whether it’s from Internet shopping or gaming or food delivery. The superstructure of consumption in China is definitely moving towards this digital economy. I think that’s a very interesting area as well.

Caroline: Yes. You bring up batteries and battery power. That’s a really good point. There’s such an important part of the fabric of, say, creating electric cars and getting fossil fuel-driven cars off the road. Of course, China is facing a fairly major challenge with COVID and a huge shutdown. How are some of these supply chain challenges coming out of China playing out across emerging markets, and how big a risk is it?

Susan: I think, right now, the COVID shutdowns are impacting things like container throughput and some obvious mobility standards when we think about the number of people, for example, using the Metro in the Tier 1 cities of Shanghai, but these COVID shutdowns are something we’ve seen in multiple geographies in multiple places. I’m from New York, and we had our own COVID shutdown. I think this is just par for the course in terms of the disruptions that are going on. The implications have really been more on the consumption demand side. I would say things like travel, things like hotel, dining-in, retail sales where you need foot traffic, those have been the most impacted from a China activity indicator purpose.

When we think about some of these more defensive areas like new economy spending, delivery logistics—those have come in to really save the day when it comes to the China COVID shutdown. I think that, clearly, it’s something that China continues to navigate. We’ll have to see what happens, but the implications have been actually pretty meaningful on the GDP impact for this quarter.

Caroline: That’s great. I want to pivot back to ESG a little bit and talk about Ashares. Canadian asset owners have been looking at A-shares as a logical jumpingoff point to investing in Chinese companies. What does the ESG landscape look like applied to say, A-shares, and how do you approach that and think about A-shares from a sustainability point of view?

Susan: A-shares are different in the sense that you definitely need to be a lot more stock level based. These are the old red chips that have been around for a long time. They’re not like China Mobile or PetroChina, like names that we’ve always known and we have a longitude of financial data [for]. When we think about these companies that are listed in [the] Shanghai composite, some of them actually have that financial longitude as well. It’s just that they have only just recently been part of the emerging market index. It really comes down to doing a lot more bottom-up work for companies that are listed in Shanghai and Shenzhen. When we think about the bottom-up work that you do from the ESG perspective, I’m just going to give you some real-world examples.

It’s going to be, for example, the understanding of the principal founder of a company, an entrepreneurial founder of a company, and really thinking about, has this founder been able to really develop a professional bench? A management team that can really expand and grow with this business? Are there any potential conflicts of interest between, say, the founding family and other family members that might be on the management team? These are some of the real-world ways that we have to really think about and question, to ask management teams when we’re talking about some of these A-share stocks mechanically: how does governance work and how does succession work and how does compensation work? What is the actual board structure? Independence ratio? A lot of these are real nitty-gritties that we have to go into.

I think the second thing that’s very interesting is just really doing a lot of comprehensive work on the landscape surrounding a company. If you’re going to invest, for example, in an electrical components company that’s listed in Shanghai, you really want to really understand the competitive set very well, and really understand how the No. 1, No. 2, No. 3 players…and really think about what’s going on from a sector-level basis—especially when you think about things like efficiency and the demand for more electrical-efficient products in China because that is, like, a major component to decarbonizing China, right? It’s like moving from less efficient old-school manufacturing to more efficient, more modern infrastructure. Those are some of the superstructured ESG questions we think about when we look at some of these great companies that are listed in the Asian market.

Caroline: Yes. It mirrors what’s happening in, say, North America, Europe, and other jurisdictions as well. We have this entire opportunity around the energy transition and creating cleaner forms of fuel and new technologies to facilitate that. You’ve touched on a few areas, but I’m wondering if you could tell me about some of the sustainability-driven opportunities you have your eye on right now in emerging markets, perhaps Asia specifically, that are getting you really excited right now.

Susan: That’s great that you say that, Caroline, because there is this rich history in both the U.S. and Europe for companies that have really pioneered electrical efficiency. Whether that’s companies like a Schneider or a U.S. company like an Eaton, there are a lot of very instrumental companies that have upgraded the global manufacturing footprint. We think one of the most important components of that is going to be semiconductors, and semiconductors that pretty much go into everything. I think that’s just what’s staggering is the movement of semiconductors to being from just your handset to laptops, to ubiquitous semiconductors. It’s like a hokey phrase. It is the true the Internet of things.

Now, you’re a refrigerator. Your car has semiconductors in it. One of the key areas in emerging markets, where there is true leadership, is semiconductor companies. That often gets hidden by the fact that semiconductors also trade in the U.S. If we take, for example…looking at the memory industry. When we think about the entire worldwide market for the DRAM, emerging market Korean companies are 90% of that market. It just shows you that for something so ubiquitous, you often don’t really know that it’s an emerging market company that’s really powering that, and is a very significant size of that. I think that’s a really good example of why emerging markets are so interesting, is you just have this leadership that is not necessarily well understood.

Caroline: Yes. Do you worry about this discussion around, say, onshoring postCOVID? Some of these essential technologies, batteries, and semiconductors…a lot of regions, or countries are thinking of rethinking their dependency on other countries for providing some of these key tools, really. Do you worry about that impacting emerging markets, or are there other drivers that are really driving that market?

Susan: I think there is a really good history of co-operation between the U.S., Korean, and Taiwan semiconductor companies. Not just from a formal investing perspective—in the sense that TSMC and Samsung are building out a lot of capacity in the U.S.—but just in the sense that an entire generation of intellectual property came out of Bell labs, and then was developed through R&D, intensive R&D, and corporate commitment from a lot of these corporate leaders, TSMC, Samsung. We think it’s a win-win situation that TSMC, Samsung, and the U.S. are really thinking about a lot of large-scale investments in North America when it comes to new capacity.

I will flip that on the head and say that it’s a positive in the sense that we’re really able to take that intellectual IPRD leadership, and domicile it somewhere else, and really make that part of the longer-term growth outlook. I would say that’s been one offshore trend that has definitely been in motion. I think there have definitely been some other alternatives. People have been looking increasingly at Southeast Asia as another form of offshore. When looking at markets like Vietnam, for example, [it] was a heavy investment market for some Korean tech companies as well, for a different workforce. I think that is definitely something that’s part of [the] constant evolution. Where do you go for your factory’s next project?

Caroline: Great. One more macro question. I keep throwing all the macro questions at you today, but inflation is quite rampant right now. Perhaps it’s transitory, perhaps not. How do you see that affecting emerging markets right now? Are there any specific emerging markets that are a little more susceptible than others?

Susan: I think the key thing right now is going to be food inflation. Food inflation is a really large percentage of most emerging market CPIs. When you combine food, and then maybe even passenger fuel, we’re talking 40% of your take-home [pay]. It’s really big. Food inflation is material. We really need to see the evolution of food inflation for the next four months. The prime food season. I would say that’s the first area to watch in terms of inflation. The second area to watch in terms of inflation is just countries that tend to have this historical net importer of oil position. Say, a Korea, or an India.