: How to use ESG to pick the winning stocks in risky emerging markets

Though the rewards are often phenomenal, investing in emerging markets is risky. Throw in environmental, social and corporate governance standards — because you give a darn about the future of the planet — and navigating the EM world as an investor gets downright complicated. But it’s worth doing, because EM offers diversification and potentially great gains.

For help with ESG + EM, I turned to Charlie Wilson, who manages the Thornburg Developing World Fund
THDIX,
-1.07%
.
He’s a good Sherpa because of his great record. Wilson and co-manager Ben Kirby have beaten their diversified emerging markets and MSCI Emerging Markets index by 4 percentage points annualized over the past three years, says Morningstar, which gives the fund five stars.

Here are four key tactics he uses, which you can apply, too.

1. Bring your own ESG standards

One of the big problems with ESG investing is defining what the heck ESG actually means. You know there’s a big problem with definitions, because third-party ratings firms so often disagree on how to rate companies. “This is great for active management because it requires us to step in and make a judgment,” says Wilson.

Big picture: Look for companies that use their resources in the best way possible. Companies that do this also perform well. Resources can mean anything from employees (improving diversity) to energy (cut carbon footprint) to board seats (more diversity, better independence). Thornburg examines about 20 categories, including women in the workforce, board independence and environment footprint.

Here’s another key tactic: You can get an edge if you notice improvements in ESG at a company before everyone else. The changes improve company performance. And as other ESG investors catch up, this too can pull money into the stock. “We call this ESG momentum,” says Wilson.

Several years ago, ICICI Bank
IBN,
-0.60%

532174,
-2.43%

in India began improving its ESG profile by putting put more independent directors on its board. This also boosted credit risk management. So loan quality improved, and the stock did well. Wilson’s fund held the name at the end of March, which tells me there’s more to go, though it did trim the holding during the first quarter.

Another example is the steel company Severstal PAO
SVST,
+0.33%
.
Even though steel production causes a lot of pollution, Wilson is OK with this name because it has pledged to reduce greenhouse gas emissions, and it has been investing heavily to do so. It has ESG momentum.

The good news for ESG investors shopping in emerging markets is that disclosure is better than you might expect. About 90% of companies offer some form of sustainability report, says Wilson.

The quality of disclosure and ESG momentum varies by country. Brazil and India are ahead of the pack. “Brazil and India have done a great job of having good board diversity and women in leadership,” says Wilson. In contrast, disclosure and board diversity lag in China.

2. Invest in strong companies

This sounds like a no-brainer. After all, who would invest in weak companies? A lot of people do, either by accident or because they are looking for that come-from-behind turnarounds. But Wilson prefers to stay with market leaders, meaning those with dominant positions in their sectors. Strong companies gain share in downturns as competitors founder. And they rebound fastest out of a downturn.

The fund identifies 400 EM companies with dominant positions and focuses on them. That makes the portfolio a good running guide to dominant companies, if you are looking for a shortcut.

“We follow these strong businesses and wait for period of volatility to get a good entry point,” says Wilson. Even the shares of high-quality companies can be more volatile in emerging markets because there are fewer institutional investors. “So stocks overshoot. You get opportunities to buy really great companies at good entry points,” he says.

One example of a dominant company is Taiwan Semiconductor 
TSM,
+0.48%

2330,
-1.93%
,
the fund’s top position at 7% of the portfolio, which is sizable. Many mutual funds limit position size to between 2% and 3% to reduce single-stock risk.

Taiwan has a big share of the semiconductor foundry space, and it is also the best at producing cutting-edge five nanometer chips. Other examples in memory include Samsung Electronics
005930,
-1.48%

and SK Hynix 
000660,
-2.85%
.
Another is Wal-mart de Mexico
WMMVY,
-1.83%

WALMEX,
-1.27%
,
which accounts for about 25% of retail sales in Mexico.

3. Get a mix of value, growth and hyper growth

A lot of EM economies are commodity-based. This makes them highly cyclical. As commodity prices bounce around, so do their economies — and corporate earnings. For a lot of investors, this kind of volatility can be hard to stomach.

To balance things out and stabilize returns a little over the economic cycle, this fund invests in a blend of value (40%), growth (40%) and rapid growth (20%). “We want consistent performance through the cycle, regardless of whether growth or value is in style,” says Wilson.

The “basic value” portion of the portfolio is mature companies with a lot of exposure to economic cyclicality, which the fund tries to buy near the low end of the cycle. Look for historically low cash flow, as a clue they are there. Wilson cites ICIC bank as an example in this category.

A growth name in the portfolio is HDFC Bank
HDB,
-0.43%

500180,
-0.30%
,
a retail bank in India. This bank has a lot of high-net-worth customers, so it tends to post fairly consistent growth regardless of what the economy is doing.

Then there are the “emerging franchises,” which are companies early in their life cycles. “They have a new business model, and they are replacing an incumbent,” says Wilson.

An example here is PagSeguro Digital 
PAGS,
-1.35%
.
It offers banking services to the “unbanked” in Brazil, like small street-corner merchants, day laborers and artists. PAGS starts off small by offering things like payment platforms. It hopes to offer more sophisticated banking services to customers as their businesses and incomes grow. PAGS is part of the media conglomerate UOL Group
UOLGY,
-0.32%

so it gets a break on advertising, which brings down the cost of winning new customers.

Another example here is Globant
GLOB,
-0.20%

in Argentina. This company helps businesses increase their online presence and use of apps to “go digital.”

4. Demand extra pay for extra risk

A big risk in EM is that your local-market investments lose value because of currency devaluation. Wilson identifies countries with the biggest risk of currency devaluation by looking for high inflation rates and big deficits.

“We estimate the long-term likelihood of losing dollar value in these markets, and we raise our hurdles to offset that loss,” he says. To do so, he requires lower valuations on entries.

Right now, a lot of companies in Mexico and Brazil offer big enough discounts. In Brazil, he cites PagSeguro Digital, and he likes Lojas Quero-Quero, which he calls the Home Depot of Brazil. This retailer has room to grow by taking market share.

Another example is Natura & Co., 
NTCO,
+0.86%

NTCO3,
+0.37%

which is using more sustainable material to make cosmetics. It recently bought Avon Products operations outside the U.S. to expand its offerings of lower-priced products. The company is based in Brazil and its biggest region is Latin America.

In Mexico he cites Grupo Aeroportuario del Pacifico
PAC,
-1.46%

GAPB,
-0.78%
,
which should benefit from more tourism as COVID-19 recedes and people travel more.

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush publishes a stock newsletter called Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

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