Assessing the EM Investment Climate and Governance Issues
Highlights from Brian Christiansen’s participation in a discussion at the Council of Institutional Investors’ Fall Conference.
The Council of Institutional Investors held its 2022 Fall Conference in Boston this September. One of the panel discussions focused on investing and governance in emerging markets. Brian Christiansen, senior portfolio manager, executive managing director, and director of stewardship at Sands Capital, shared his thoughts as a member of this panel. Following are highlights of the discussion, with Brian’s responses to questions posed by the panel moderator and conference attendees.
What is your current perspective on emerging markets, and what do you see as the unique features of investing in this market?
Brian Christiansen: As a co-portfolio manager on Sands Capital’s global and emerging markets strategies, I would say the best way to describe our investment style is that we take a private equity-like approach to investing in public equity markets. What I mean by this is that we try to build a portfolio of about 35 businesses that we think can grow for periods much longer and at rates much faster than the markets anticipate.
We do a lot of fundamental research upfront to build our conviction in those businesses and then we typically own them for a long period. Our average holding period for stocks in our portfolios is five to seven years, but we have instances when we’ve owned a business for 10 years to 15 years or more. Those have often been our best investments.
When it comes to investment stewardship and encouraging strong environmental, social, and governance (ESG) practices, I think this long-term orientation positively influences how you can engage with companies. Being a long-term investor greatly increases the probability that you can have an impact as you partner with companies to manage risks and identify opportunities to address ESG issues.
What special considerations are you making today with regard to investments in China, particularly related to the central government’s recent willingness to exert more control over certain industries?
Christiansen: In line with our approach of taking a fundamental, bottom-up view of businesses, we prefer businesses that can, to a certain degree, create their own weather from a macroeconomic perspective. That being said, we’re also very much aware of the macro issues, and we build a macro framework for each country where we invest.
To simplify the analysis, we look at three major categories. First, we examine the income statement of a country, and what its drivers of growth are. We also look at the balance sheet of a country, which provides a sense of currency vulnerability. Finally, we consider the governance of a country, both in terms of its political structure and the strength of its regulatory institutions. That third bucket [governance] is where we currently have some of our greatest concerns with China because it appears to be at a pivot point.
Many investors historically have tied economic growth in emerging markets to the strength of democracy in a country. The data demonstrating the correlation between those two is not very strong, though. Long-term economic growth is, however, closely tied to peaceful transfers of power and property rights. Neither of those circumstances are as strong as they once were in China.
From an investment standpoint, these increased regulatory risks and weakening of institutions in China mean that whatever we were willing to pay per unit of growth in China now has to be lower. You need a valuation framework that builds in the higher cost of capital for investing in China. For me, this is not simply a short-term cyclical issue but a consideration that must be accounted for over the intermediate and long term.
With regard to the impact of all these developments on portfolio allocations, we now have zero percent in China for our global strategy. For our emerging market (EM) strategy, China does represent a big part of the benchmark index and the opportunity set for these markets. But we now have about 20 percent of our EM portfolio in China. That is about 10 percentage points below China’s weight in the MSCI EM index. It’s one of the largest underweights we’ve ever had in China for this portfolio. It could go down even further if the trends worsen because, as concentrated investors, we are willing to not invest in a country when the fundamentals warrant it.
What can we do as investors to express our concerns? Is it possible to engage with Chinese companies and policymakers?
Christiansen: I would say yes. Just as it’s important not to lump all the emerging market countries together because they’re not homogenous, it’s also essential not to consolidate all the components of ESG under a single acronym. While we have concerns about the regulatory and business environment in China, you can still effectively engage with Chinese companies on environmental issues like water usage and pollution, for example. We have Chinese companies in our EM portfolio that are starting to be very thoughtful about their path toward decarbonization. On the social front, we tend to be invested in companies that are in very innovative parts of the economy. The recruitment and retention of employees are incredibly important, so companies are very thoughtful about social issues related to the treatment of workers.
It is more difficult to engage with companies on any topics that are deemed to be sensitive for the government. These companies are headquartered and operate in China, so they’re under the rules of China. Right now, any issues related to the cotton supply chain are very sensitive. So, too, are data privacy and security and related human rights.
One of the things you must decide, in terms of engagement as an investor, is what the probability of success is. For many of these topics, the probability of success is much lower. You can have opportunities to improve some issues, but you cannot change the overall construct in which these companies operate.
How does the current macroeconomic environment, which combines accelerating inflation and rising interest rates, affect your approach to emerging markets?
Christiansen: One of the things you must think about is that with some emerging markets a higher proportion of their economies is tied to the consumption basket with items like food, energy, and electricity. When you’re engaging as a steward in a highly inflationary environment, you must recognize and have empathy for the hierarchy of needs, even with regard to issues that you may care deeply about, like the path to net-zero carbon emissions.
To meet the hierarchy of needs for these companies’ consumers, it is very important for these emerging markets to be able to achieve long-term growth, reduce inflation, and have healthy supply chains and good cost structures, all while contributing to the health of the planet.
At the company level, it is all tied to capital allocation decisions. As you assess how companies are making those decisions, governance again becomes very important. The approach to governance issues in emerging markets can be influenced by the fact that these markets have a high percentage of founder-led and family-run businesses. In our experience the best entrepreneurs and families often have the longer-term views and disciplined capital allocation that can generate strong returns. But there are also risks that can occur with some of these organizations, stemming from potential conflicts of interest, nepotism, and a host of other issues.
As an investor, your ability to use your judgement and understand what type of entrepreneur or family is running the business will be critical. When a company has the right type of leaders, investors can help them build the governance structures that can lead to value creation. That is one of the reasons why we believe engaging on governance can be a powerful tool, and that is especially the case in emerging markets.
How are you assessing and managing the investment risks of a potential invasion of Taiwan by China?
Christiansen: We think this is a low-probability event, but you still must consider the possibility, and we have reduced our exposures somewhat to account for it. Quite frankly, if this does happen, there will be a lot of unintended consequences that are hard to understand beforehand.
An invasion would have a massive impact on the semiconductor supply chain, and that would affect China, the United States, and the rest of the world. The supply chain issues we have today, as a result of the pandemic, would pale in comparison to the supply chain issues this event would create. It is a very complicated issue, especially when you consider that TSMC [Taiwan Semiconductor] is the world’s leading-edge chip manufacturer. It is well ahead of any other competitor, including Intel.
The facilities of TSMC are key, but so, too, is its human capital. There are not a lot of people outside of Taiwan who have the knowledge and experience to run these facilities. The sanctions on Russia after its invasion of Ukraine demonstrate the geopolitical risks for a country that embarks on such actions. Still, even if the probability of China taking similar action against Taiwan seems low, as an investor you need to have a gameplan to prepare for that possibility.
What opportunities are investors finding to encourage companies to have more efficient use of scarce resources, like water?
Christiansen: Often, the bigger questions come down to whether an externality, such as water usage, can be internalized as a cost consideration. For example, when it becomes clear to a company that their management of a resource like water can have a positive impact on their profit and loss statement, they’ll often quickly find innovative solutions to address the issue. As an investor, there are things you can do to make your engagement on these matters more effective, like demonstrating how a company compares with others in its sector or geography and how being a more effective steward of rare resources, like water, could become a competitive advantage for the company.
The challenge for many emerging markets is that some of these resources, like water, are mispriced in these geographies. With more effective pricing, it can be easier for companies to make these externalities an internalized cost. With regard to impact, I think supporting effective pricing of these resources is an area where efforts can be most productively allocated.
There are also a number of companies with discrete technologies that can enable companies to better address a broad range of ESG challenges. Many of these companies are on the private equity side. At Sands Capital, we do have a venture capital capability that has led us to certain technology opportunities within the United States. We believe a large proportion of public companies could benefit from the solutions these technologies offer for addressing ESG issues.
What is your view of investing in frontier markets? Do these markets require a different approach when investing in and engaging with companies?
Christiansen: My short answer is yes, but only because I believe every market demands a unique approach. Across all the emerging markets, there is variability with how you engage within each country, within each sector, and with each company. Too often, emerging markets are lumped together. That is often the case even with nonfrontier markets like South Korea, India, and China. But you need different approaches with each of these countries. So my colleagues at Sands Capital and I are big believers in the importance of using your judgement and tailoring your approach to each geography and each business.
 Sands Capital’s Emerging Markets Growth strategy held 20 percent of its assets in China as of September 30, 2022, and 16 percent as of October 31, 2022.
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Taiwan Semiconductor is the only Taiwan-based chip manufacturer owned by Sands Capital portfolios and is used to illustrate an example of how a chip company and its supply chain could be affected if China invades Taiwan.
A full list of portfolio holdings, including portfolio holdings purchase dates are available on www.sandscapital.com.
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