With the growth of sustainable investing and expected long-term contribution of emerging markets (EM) to the global economy, it is inevitable that investors are increasingly focused on environmental, social and governance (ESG) factors in the developing world. Improving company disclosure has helped to broaden horizons – investing sustainably is easier where ESG data is readily available and has been reported for longer. The recognition of ESG as a potential source of alpha and the incentive of possible financial rewards has further boosted capital flows to emerging markets. As a proxy, the MSCI EM ESG Leaders Index has outperformed the broader benchmark (see figure 1) while companies who take sustainability seriously should intuitively be less risky.
ESG has been an important part of SKAGEN’s fundamental research since the turn of the century and analysing the sustainability of business models has always played a key part in assessing the investment case for companies in both developed and emerging markets.
As an extract from our 2005 Market Report (figure 2) outlined: “We focus on long-term profitability, rather than the realisation of short-term profits, of the companies we invest in. This means that we consider whether [they] may be assuming material and undesirable liabilities through activities that are dangerous to one’s health, abusive to the environment or that may fall foul of future changes in legislation”.
Our ESG analysis has evolved over the past two decades and is now more forward-looking and returns-focused, while the growing threat of climate change and our need for a changing energy mix has also provided opportunities to invest in emerging market companies that are playing a key role in our transition to a greener world.
Our active approach means that we can focus on the positive drivers of ESG at attractive valuations to harvest excess returns for clients.
Valuation discipline
Active investors like SKAGEN Kon-Tiki can typically access these companies in three ways, as Fredrik Bjelland, the fund’s co-manager, explains: “Firstly, businesses making environmentally friendly process improvements to operate more efficiently, such as industrial and manufacturing companies. Secondly, those with the expertise to help clean-up environmental damage or pollution, such as water treatment companies. Finally, and perhaps most positively, companies providing green energy solutions to help reduce CO₂ emissions, such as electrification, solar and wind power.”
For those with a focus on value, the challenge is often that technologically advanced companies successfully operating in growth markets such as these often come with a premium price tag. The portfolio managers therefore often find better value in businesses where the positive environmental impact is secondary rather than primary.
Kon-Tiki has been a long-term investor in LG Chem and Samsung SDI, for example, which combined manufacture around 16 percent of the world’s lithium-ion batteries used to power electric vehicles (EVs)[1]. Both companies should benefit from the expected growth in demand for electric cars as motorists seek to reduce their carbon footprint (see figure 3). SKAGEN’s ESG Specialist, Sondre Myge Haugland, explains: “The transport sector accounts for 28 percent of global energy demand and has seen the fastest growing CO₂ emissions over the past half century, currently contributing 23 percent of total energy-related emissions[2]. The electrification of vehicles and transport networks more widely is likely to play an important role in successfully meeting climate change targets.”
Another Kon-Tiki holding is Ivanhoe Mines, which part owns one of the world’s largest copper discoveries, Kamoa-Kakula, in the Democratic Republic of Congo. Haugland continues: “Copper will also play an important role in creating a greener world, comprising nearly ten percent of EV batteries while the vehicles themselves use up to 80 percent more copper than traditional ones[3]. More significantly, wind and solar power require up to 15 times more copper per unit of output than fossil fuels with the upshot that pricing is expected to increase substantially to meet growing demand.” Bernstein analysts predict a 40 percent rise from current levels will be needed to meet 2030 decarbonisation targets which would boost the major producers like Ivanhoe Mines significantly.
Virtuous circle
Tackling climate change is one of the 17 UN Sustainable Development Goals (SDGs), which aim to promote equality and prosperity while protecting the planet. Several of Kon-Tiki’s holdings contribute directly and indirectly to these, for example Beijing Enterprises Water Group, which provides environmental protection services (SDG 6: Clean water and sanitation) and Orbia, which provides drip irrigation systems to boost agricultural yields (SDG 2: Zero hunger) and fluorine-based products to the healthcare sector (SDG 3: Good health and well-being). It is widely recognised, however, that much greater capital is required to achieve the SDGs by 2030 with the UN estimating the financing gap at $2.5 trillion per year in the developing world alone[4].
While SKAGEN Kon-Tiki is not an ESG fund – the portfolio managers’ primary focus will always be to maximise financial returns but in a sustainable way – this illustrates the size of the emerging market opportunity. As Bjelland concludes: “Our active approach means that we can focus on the positive drivers of ESG (as well as excluding negative ones) at attractive valuations to harvest excess returns for clients. By investing in well-run companies which provide sustainable solutions in growing markets, all stakeholders and wider society should benefit alongside their shareholders”.
Case Study: Atlantic Sapphire
One of Kon-Tiki’s largest holdings (3.0% of NAV) is revolutionising salmon farming by bringing it on land to help provide a healthier diet without damaging the well-being of the planet. As well as preventing ocean pollution, Atlantic Sapphire has located its innovative ‘bluehouse’ in Florida to meet demand from US consumers while avoiding air freight. It will produce healthier salmon – one of the most sustainable proteins available – without antibiotics and which are free of microplastics. The waste generated can also be used as fertilizer or to create renewable energy in the form of biogas.
In addition to its ESG credentials, the company has also been a hugely successful investment and was Kon-Tiki’s third largest contributor in 2018 and the sixth best year-to-date. The fund has backed Atlantic Sapphire since 2017 and invested at a critical stage of development to ensure the company’s own sustainability. Despite the share price almost quadrupling since the start of last year, we still estimate further upside of over 70 percent if the company’s expansion goes according to plan over the next year.
NB: Figures as at 30 September 2019
References
[1] Source: SNE Research
[2] Source: Intergovernmental Panel on Climate Change
[3] Source: Visual Capitalist
[1] Source: United Nations Conference on Trade and Development