Environmental, social and governance fund proliferation is usually fueled by the marketing mantra that investors can “do well by doing good.” While that’s no doubt true, ESG criteria are all too often a check-the-box exercise at both the fund and the company levels. Many ESG funds default to outsized tech holdings or include companies that talk the ESG talk but fail to walk the walk, otherwise known as “greenwashing.”1 Conversely, ESG data vendors often tag some firms with low sustainability ratings, even as those companies make genuine and concerted efforts to improve their sustainability.
Such “ESG momentum” plays can become great investments both in terms of their sustainability and return potential. But properly assessing their relative progress across sectors and culturally diverse geographies, particularly in emerging markets, is no easy task. We believe sound judgment is just as crucial in ESG research as in traditional financial research. In the following Q&A, Thornburg Portfolio Manager Charlie Wilson, who co-leads the firm’s emerging market strategies, explains how the team defines and conducts ESG research, which is part and parcel of its traditional financial research and ongoing company monitoring.
Q: Many ESG-focused funds seem to start with negative screens that simply filter out companies in potentially problematic industries. How should ESG filters be implemented?
CW: Our research broadly aims to capture the costs of both positive and negative externalities. That’s why we don’t just conduct negative screens. Positive externalities can be reflected in lower cost of capital thanks to decreased liability risks, while negative externalities can manifest in higher capital costs due to, say, high energy intensity, water usage or greenhouse gas emissions.
Enhancing traditional financial analysis with extensive ESG-derived metrics gives a fuller financial picture, which can inform a more realistic discount rate and allow for more accurate earnings and cash flow projections, in our experience. Generally, we just think companies whose strategy or business model is based on amplifying positive externalities while reducing or eliminating negative externalities will benefit from higher confidence in the sustainability of free cash flow generation, a lower cost of capital, and the potential to increase reinvestment opportunities over time.
Q: Does market volatility within emerging markets create a particularly favorable environment for truly active managers?
CW: These regions have less mature capital markets and a smaller institutional investor base; they have higher economic cyclicality and currency volatility; more regulatory and political risks, not to mention uneven ESG standards. The high frequency of factor rotations between growth and value in EM in a way also speaks to the volatility in the space. In many situations, these elements also work together to amplify investor optimism or pessimism, driving stock prices farther away from fair value than might be observed in developed markets. In EM these inefficiencies and dislocations exist across sectors, geographies, market capitalizations, levels of business quality, and investment styles such as value, growth and quality. We aim to exploit these inefficiencies by marrying each investment team member’s broad expertise, deep fundamental analysis, and insights on non-financial business characteristics with the ability to assess the impact of externalities and better gauge risk and reward across a huge opportunity set—the index alone comprises more than two dozen countries.
* Based on the Eurozone domiciled segment of the MSCI World Index
Source: FactSet and Sustainalytics
Q: How does that work at the stock level?
CW: In our stock selection process, we focus on vibrant companies with attributes that we believe mitigate business-related risks: durable firms with a leading or growing market position; strong, quality leadership and governance; and the ability to fund their own growth, so they are usually free cash flow positive. They must also trade at attractive prices for us to establish or add to a position, so we also have some margin of safety.
We also build in a macro overlay due to currency risk sensitivities, which depend largely on domestic current account or fiscal deficits, or both, local benchmark interest rates and inflation. In these instances, the price targets of our positions must meet, if not exceed, our return hurdle rates based on potential local currency depreciation, as our investors are mostly U.S.-dollar based. But there are always at least a few great companies to be found in countries that are passing through a rough patch economically; those firms that demonstrate resilience in the tough times tend to thrive over full market cycles and can be excellent investments.
Lastly, every position must offer a “path to success,” catalysts or milestones that should propel it to close the discount we see in our assessment of its intrinsic value. Having clear milestones makes it easier to track the progress of our investment thesis on each stock in the portfolios.
Q: You run rather concentrated strategies of just four to five dozen positions. Doesn’t that generate greater volatility at the portfolio level? How does your portfolio construction process address that?
CW: Well, again, it starts at the stock level. You would be surprised how a strong company in a promising market can not only survive but thrive in challenging economic times, taking share from other, less thoughtful competitors that don’t address the needs or interests of all stakeholders. By the way, those include not just clients, shareholders and majority owners, but obviously employees, suppliers and local communities. Now at the portfolio level, we think we can better achieve our performance goals by making larger, more meaningful investments in a highly select, and well diversified, set of our best ideas. By focusing capital in our highest-conviction stocks, our portfolios naturally have fewer holdings, larger average weights, and more capital in the top ten positions, which usually make up just more than 40% of the portfolios.
So, on portfolio construction, while we’re always aware of absolute and benchmark- relative volatility, for us it’s rather secondary to the longer-term return potential of the portfolios. We do think our portfolio construction helps to mitigate the impact of volatility by diversifying our investments across market segments with different underlying business drivers. Given our stock selection, the portfolios tend toward quality and growth, but their diversification goes beyond standard country parameters.
Founded in 1982, Thornburg Investment Management is a privately-owned global investment firm that offers a range of multi-strategy solutions for institutions and financial advisors around the world. A recognized leader in fixed income, equity, and alternatives investing, the firm oversees US$45 billion ($43.3 billion in assets under management and $1.8 billion in assets under advisement) as of 31 December 2020 across mutual funds, institutional accounts, separate accounts for high-net-worth investors, and UCITS funds for non-U.S. investors. Thornburg is headquartered in Santa Fe, New Mexico, USA, with additional offices in London, Hong Kong and Shanghai.
For more information, please visit www.thornburg.com