Emerging markets: trends, opportunities & ESG
February 26, 2021 with Ian Smith and Paul Birchenough
Why invest in emerging markets now? What are the current trends and opportunities? And why the integration of ESG factors is so important, especially in emerging markets? A two-part discussion with Paul Birchenough and Ian Smith of Newton Investment Management (North America) Limited.
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Terry Dimock (TD), Paul Birchenough (PB) and Ian Smith (IS)
Welcome to NBI podcasts. My name is Terry Dimock, Chief Officer of risk and execution at National Bank Investments. I’ll be your host today for this really interesting discussion on emerging markets.
Before we get started, let’s get a couple disclaimers out of the way. BNY Mellon Asset Management Canada Limited is the subadvisor who in turn has hired Newton Investment Management Limited as a sub-subadvisor of the NBI Diversified Emerging Markets Equity Fund. BNY Mellon Asset Management and Newton are affiliates. This podcast is for general information only, is subject to change, and pertains only to the portion of the Fund that is managed by Newton and is current as of January 25, 2021. References to a country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors.
My guests for this podcast are Paul Birchenough and Ian Smith, portfolio managers in the Equity Opportunities team at Newton Investment Management and co-managers at the NBI Diversified Emerging Market Equity fund. Hi Paul and Ian. Thank you for joining us on this podcast.
Hi Terry, thank you very much indeed for hosting us.
So let’s start with Paul and why don’t we begin with a simple question. Why invest in emerging markets now?
Well, first off, it’s intuitive that emerging market equities is an asset class that should outperform developed market equities over the long term.
Over 80% percent of the world’s population reside in low and middle income countries and in fact even more of the world young population and yet emerging markets only constitute little more than 10% of the representative world equity index. This is corroborated by the fact that EM equities have outperformed over the long term, having delivered over 10% annualized returns in U.S. dollars since 1987, exceeding the annual returns in developed market equities by almost 2.5%.
However, it’s very interesting to note that over the last 10 years, emerging market equities have only delivered 4% annualized returns. And in fact, it lagged developed market equities by over 6% per year. In fact, emerging market indexes only just broken through 2007 level in the past month. This underperformance suggests to us so that might be an attractive time for long-term investors to revisit one of the fastest growing asset classes on offer. The performance of emerging market equities has started to turn more recently, having outperformed developed market equities by 23% since last May.
This is within a backdrop of a weakening U.S. dollar that tends to be supportive of the emerging market equities. The massive amounts of fiscal stimulus in the U.S. and other developed markets over the last 12 months relative to China and other emerging markets certainly helps the relative outlook for currencies in EM, which should drive their outperformance. Flows into equity mutual funds have picked up, although data would suggest that people are still under invested in EM relative to where they have been historically. So there are clearly some tactical reasons to do revisit EM, but it’s a long term opportunity that excites us and it’s where we have most conviction. This is based on reliable long-term themes and trends, for example:
- Growing online consumption in China supported by broadening middle class and falling domestic savings rates.
- Also, growing penetration of vastly underrepresented products and services from paints and cars to mortgages, pensions, insurance and e-commerce.
- And finally, emerging markets are global leaders that claim global megatrends such as electric vehicles and renewable energy growth.
We think there’s a unique opportunity in EM for companies who were exposed to these reliable trends and that can exploit the opportunities in the superior manner to their peers by virtue of their differentiated customer offering and execution.
Wow, definitely seems like a lot of interesting opportunities in there. It’s a pretty vast market. So maybe, Paul, you could tell us a bit about your approach in investing in emerging markets, and maybe some of the current trends and opportunities.
Sure. Emerging markets by their very nature provide exposure to high growth potential but are often characterized by short-term markets or economic gyrations, which sometimes deter investors from investing in the asset class. Our approach is to provide a highly selective investment portfolio that aims to capture the best growth potential in emerging markets while minimizing risk. Our strategy is actively managed; that means we’re selecting what we perceive to be the best companies and then investing with high conviction and limiting the number of companies we hold to those very best opportunities. Our approach is a combination of identifying attractive themes and trends and bottom-up fundamental analysis, or in other words, identifying the best companies that should benefit from positive trends we speak about.
We take a rigorous bottom-up approach to company selection and seek companies with specific characteristics which we believe are likely to drive good long-term returns. We’re looking for good quality and growing companies, considering each investment over at least five years. A long-term investment horizon is a key differentiator and we avoid chasing short-term market gyrations. A key element of Newton’s investment process is the use of themes which we evolved to reinforce long-term perspectives.
This systematic approach helps us to maintain focus on exciting and really very reliable growth trends. Some of these key themes they’re exposed to are electric vehicles, or EV, renewable and smart energy, and the Indian consumers. I’ll just touch on these briefly. EV penetration is clearly growing and is expected to make up around 40% attached to car sales by 2030. Even in December 2020, 24% of cars sold in Europe’s three largest markets were EV, versus just 4% 12 months prior to this. This creates a new need for batteries with forecasts over 20% annual growth rate for battery requirements over the next 10 years. Companies in China and Korea will no doubt be amongst the global leaders in this space.
Another exciting area is renewable energy, but Chinese companies are already global leaders. For example, in solar energy, global renewable energy capacity is forecast to grow by 50% between 2019 to 2024. This increase would be the equivalent of the total capacity in the U.S. We’re really at the inflection point with current average cost of solar in China having been reduced by 18% in the last 10 years. Solar will have cost advantages against fossil fuels. And a lot of new renewable capacity will be in solar, and we’ll see some strong winners of this trend in China.
The third important theme I mentioned is the Indian consumer. The opportunity here is exceptional that when presented with a large addressable market, fragmented industries and underpenetrated products and services. The modern consumer economy, which finds households with earnings in excess of $4,000 USD, is expected to double to around 330 million people in less than 10 years. Currently car ownership in India is where it was hundred years ago in the U.S., and mortgage penetration is currently 10% of the economic output, which is where it was in the U.S. in the 1950s. Clearly there are many long-term opportunity in the consumer space in India.
Well, thank you very much Paul. That’s definitely very enlightening. Let’s go on to another really important topic. When NBI selects managers, we use our OP4+ process, and the + is really how managers integrate ESG factors. In this really vast market, a lot of different geographies, governments, regulations, I’m sure it’s really important. So maybe, Ian, you could give us a little more insight on why ESG integration is so important. Especially in emerging markets.
Hi Terry, thanks for the question. As you say, this is actually a very important question. At Newton, we believe that the integration of ESG when considering investment is very important, in all asset classes in fact. It helps you to better identify and assess business risks, but also to think about potential opportunities.
So in our mind, ESG is something that is relevant for long-term shareholder returns and that’s why we take it so seriously. We believe that ESG integration, though, is especially important in emerging markets. There’s more companies that are controlled by the state or promoter groups and so there’s greater scope for conflict of interest. Also, you might be aware that ESG-related disclosures are a bit more patchy in emerging markets and ESG-related policies and codes of conduct are less formalized.
So all of this means that typically you’ll see lower ESG scores in emerging markets, and you will in develop markets and so essentially there’s more pitfalls and risks in emerging markets. And so it’s especially important to understand those risks and navigate around them. However, an ESG framework also allows us to potentially take advantage of positive ESG factors, if a company is aspiring to be very much best in class. So as Paul’s already discussed, we believe that emerging markets offer fairly unparalleled growth opportunities against pretty much any other asset class. And so ESG integration in our minds helps our clients to get exposure to the very best of what emerging markets has to offer and to avoid the worst. So whilst there’s some bad companies out there, there are also some truly outstanding companies in EM that do things the right way. And this is where we’re looking to invest.
At Newton we have a six-person and growing responsible investment team that help us as portfolio managers to better understand the ESG risks and opportunities of a company. And they produced ESG quality reports for us that helped give us further insights. In fact, it’s requirement at Newton that all knew holdings require such report to be written before we invest. We have all the resources that we feel we need to make those assessments such as databases and third-party reports. But also, as a portfolio manager is we have a critical role to play on the front line. We need to continually see engage with the management teams of the companies that we invest into and to challenge them where appropriate.
Ultimately, we need to know that we can trust the company and that we are aligned in terms of our expectations for future success. But I don’t want to give you the impression that ESG integration only helps us to avoid pitfalls, because it can actually also help us to identify growth opportunities. By thinking about underserved needs, which are often defined by the UN Sustainable Development Goals, we’re also thinking about potentially large addressable market opportunities. Sadly, it’s the case that over two people billion people – that is globally – do not have safely managed water drinking water and over four billion people go without safe sanitation services.
CO2 emissions on a GDP relative basis for lower and middle income countries is 60% higher than for high income countries, so clearly companies that can profitably sell solutions to these issues will be really well exposed along growth runways. We like this sort of win-win situation, where we see profits, growth and people getting the things that they need. Again, this is where we’re looking to invest, and to put our clients’ capital.
I’ll just leave you with an interesting statistic. So there’s a representative EM ESG leaders’ index which should really be composed of those companies exhibiting the best in class ESG qualities, and it’s outperformed the more traditional, broader EM index by roughly 3% annualized since September 2007. And we’re not surprised by this. And so just imagine the scope for superior investment returns from an active manager that came utilise this ESG integration in emerging markets in a very focused manner. And we hope and believe that we can meet this challenge.
Thank you Paul and Ian and thank you to our listeners to the NBI podcast. Today we spent time understanding emerging markets and specifically on why it’s interesting right now. We also heard about Newton’s investment approach and a few market themes that I think are interesting in the long-term. And finally, we just heard from Ian who spoke about the importance of ESG integration to manage risk but also to identify opportunities in emerging markets. So have a good day everyone. And please don’t hesitate to reach out to an NBI representative if you have any further questions. Thank you.
Chief Investment Officer and Strategist, National Bank Investments
Martin is the Chief Investment Officer of National Bank Investments responsible for the development investment soclutions and the management of tactical asset allocation mandates. With over 20 years of experience in financial markets, Martin also managed the portfolio management team at Private Banking 1859.
Ian était co-gestionnaire de portefeuille d'Axa Framlington sur les marchés émergents mondiaux. Auparavant, il a été analyste financier chez Matrix Group et Nevsky Capital. Ian a commencé sa carrière en faisant de la finance d'entreprise et des fusions et acquisitions dans plusieurs grands cabinets d'expertise comptable et banques d'investissement. Ian est un comptable agréé et est titulaire d'un diplôme en économie et en politique de l'Université de Durham.
Equity Team – Emerging and Asian Markets
Prior to joining Newton, Paul was co-lead portfolio manager of Axa Framlington’s global emerging markets capabilities. Before that, he was a Latin America investment analyst at Nevsky Capital, where he met Ian Smith. Paul began his career at KPMG in the audit, transaction services and corporate finance teams covering the technology, media, and telecom (TMT) sector. Paul is a chartered accountant and attended the University of Nottingham where he studied mathematics.