Why is ESG important in emerging markets? - Dalton Investments (2024)

Dalton Investments LLC (“Dalton”or “we”) utilizes a value investment approach that seeks to invest in companieswith sound, sustainable businesses, operated by managements whose interests arealigned with shareholders. Client portfolios are built one security at a time;each security being selected on its own merits, through rigorous bottom-upfundamental analysis that starts with a checklist of questions, including thosespecific to Environmental, Social, and Governance (“ESG”) issues. We believe that taking a holistic approach torisk assessment for each individual company, particularly for those operatingin emerging markets where corporate governance is less developed and the ruleof law less well-established, can, to some degree, potentially mitigate riskand, according to some studies, may help to generate superior long-termrisk-adjusted returns.

Our process does not begin byexcluding companies based on environmental or social risks. Rather, Dalton’sinvestment team includes ESG risk criteria in its evaluation of emerging marketcompanies, focusing on governance issues (including board composition,management compensation, dividend policies, capital allocation andcontroversies), social issues (including labour policies, product quality andsupplier code of conduct), and environmental issues (including emissions andwaste policies, resource management and sustainability goals). Daltonsupplements its ESG research with a dedicated, third-party ESG specialist, whoprovides independent analysis.

Additionally, Dalton takes anactive stewardship role as an owner of its portfolio companies. Many of ourportfolio companies are run by entrepreneurs whose focus on long-term successis accompanied by sound ESG policies. But where possible and when deemed beneficialto our investors, Dalton actively engages with company management seeking topromote positive change on ESG matters, particularly governance issues. We believe that dialogue with investeecompanies on both a private and a public basis are ways to add value to ourinvestment process.

On the following pages, we outlinea review of a range of the existing, externally-published studies on ESGinvesting and discuss their assistance in shaping our process.

Therelationship between ESG and financial performance

In developing our understanding of thepotential or possible relationship between ESG factors and financialperformance, our team has reviewed numerous studies by leading academicinstitutions and professional entities.Please note, however, that no representations or warranties, eitherexpressed or implied, can be made as to the data and analysis provided in thefollowing studies. The data analysis has been prepared by the respectiveauthors and entities, and Dalton has not verified any of the studiesindependently. The views and opinionsexpressed in the studies are those of the authors and do not necessarilyreflect the opinion of Dalton.

The following studies have been instrumentalin shaping our thinking in the areas of ESG:

1. Corporate sustainability: first evidence on materiality¹
2. The impact of a corporate culture of sustainability on corporate behaviour and performance²
3. Sustainable investing: establishing long-term value and performance³
4. Do social responsibility screens matter when assuring mutual fund performance?⁴

The study Sustainable Investing:Establishing Long-Term Value and Performance published by Deutsche Bank in 2012is of particular interest because it is a meta study that consolidated over 100published research papers on ESG and performance and risk. The study makes thefollowing conclusions:89% of the studies that Deutsche Bank examined show companies with high ESG ratings exhibit market-based outperformance, while 85% show accounting-based outperformance (e.g., higher return on assets, return on equity).

1. 100% of the academic studies agree that companies with high ratings for corporate social responsibility and ESG factors have a lower cost of capital in terms of debt (loan and bonds) and equity.
2. 89% of the studies that Deutsche Bank examined show companies with high ESG ratings exhibit market-based outperformance, while 85% show accounting-based outperformance (e.g., higher return on assets, return on equity).

Market performance

Overthe past decade, in response to growing investor need for transparentinformation on ESG performance, MSCI Inc. developed a range of ESG indices toprovide measurable performance track records of leading companies in the ESGspace, using its own ESG risk assessment methodology.

One such example is the MSCI Emerging MarketsESG Leaders Index⁵, a capitalisation weighted index that providesexposure to companies with high ESG performance relative to their sectorpeers. The index was established in September2007 by MSCI Inc.

Please note that Dalton has not independentlyverified or reviewed any of the constituents in, or the data used in creating,the MSCI Emerging Markets ESG Leaders Index and that Dalton makes no claims,promises or guarantees about the accuracy, completeness or adequacy of theconstituents in the index or the underlying data that MSCI Inc. may have usedin creating the index.

Through the end of April 2019, the MSCIEmerging Markets ESG Leaders Index had outperformed the broad MSCI EmergingMarkets Total Return Index by 3.7% per annum.It achieved this outperformance with lower overall standard deviation ofreturns (17.0% vs 18.0% over the past ten years) and consequently had a higherSharpe Ratio since inception (0.31 vs. 0.15).

MSCI Emerging Markets ESG Leaders Index

(Cumulative Index Performance Sep. 2007 – Apr.2019)

Our approach to ESG

Basedon our research on ESG, we have made the following changes to more formallyinclude ESG factors into our investment process:

1. We expanded our existing 4-Mantra approach6 to specifically include ESG items in our due diligence checklist.
2. We added a dedicated, third-party ESG specialist to supplement our existing research into companies.

Our ESG process

OurESG research specialist adopts the following approach in assessing ESG inexisting and prospective investments.

1. Review relevant corporate and sustainability disclosures
2. Analyse available ESG data sets
3. Check for controversies and legal disputes
4. Check for fraud using proprietary accounting fraud analysis tool
5. Prepare company ESG report for investment team
6. Engage with investee companies where necessary

The ESG report also assigns asubjective ESG ranking of A, B, C or D, where A = high quality practices, B =moderate quality practices, C = low quality practices, and D = requesting aseparate, additional ESG review by the analyst team.

Within the overall assessment,our ESG specialist provides a qualitative assessment of the company’s risk asit relates to ESG, accounting, litigation and any other relevant risks that maypotentially impair earnings. The qualitativeassessment may lead our investment team to further engage with the company,from an ESG perspective.

How our ESG processdiffers from third-party vendors (e.g., MSCI, Asset4, Sustainalytics)

1. Wedo not use ESG as a screen, rather we integrate ESG into our investmentapproach.
2. Ourapproach is not biased by market capitalization.
3. Ourapproach places a greater emphasis on alignments of interest and corporategovernance.
4. Whendeemed appropriate, we directly engage with companies on ESG matters, with afocus on governance issues, and have clearly defined voting policies.
5. Ourprocess incorporates the use of accounting fraud tools to raise red flags tothe overall efficacy of the financials.

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1. Khan, Serafeim and Yoon (2016). “Corporate Sustainability: First Evidence on Materiality.” The Accounting Review. Vol. 91, no. 6 (November): 1697-1724.
2. Eccles, Ioannou and Serafeim (2012). “The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance.” The Harvard Business Review. Working Paper 12-035.
3. Fulton, Kahn, Sharples (2012). “Sustainable Investing: Establishing Long-Term Value and Performance.” Deutsche Bank
4. Briere, Peillex, Ureche-Rangau (2017). “Do Socially Responsibility Screens Matter When Assessing Mutual Fund Performance?” Financial Analysts Journal v73.n3.2.
5. The MSCI Emerging Markets (EM) ESG Leaders Index, is a capitalization weighted index that provides exposure to companies with high Environmental, Social and Governance performance relative to their sector peers. MSCI EM ESG Leaders Index consists of large and mid-cap companies across 24 Emerging Markets countries. The Index is designed for investors seeking a broad, diversified sustainability benchmark with relatively low tracking error to the underlying equity market. The index is a member of the MSCI ESG Leaders Index series. Constituent selection is based on data from MSCI ESG Research. Latest factsheet is available at https://www.msci.com/documents/10199/c341baf6-e515-4015-af5e-c1d864cae53e.
6. Dalton’s 4-Mantra approach is focused on investing in good businesses, where there is a significant margin of safety, where there is an alignment of interest to the owner/operator, and where there is an identifiable a strong track record of reinvesting capital.

This document is provided for informational purposes only, and doesnot constitute a solicitation of any shares in any investment vehicle managedby Dalton Investments LLC. Suchsolicitations can only be made to qualified investors by means of the privateplacement memorandums, which describe, among other things, the risks of makingan investment. Additionally, thispresentation does not constitute investment advice of any kind.

All of the information in this document relating to DaltonInvestments LLC or its affiliates (collectively, “Dalton” or the “Firm”)is communicated solely by Dalton, 1601 Cloverfield Boulevard, Suite 5050 N,Santa Monica, CA 90404, regulated by the U.S. Securities and ExchangeCommission (SEC). (SEC registration doesnot imply SEC endorsem*nt.) Norepresentation or warranty can be given with respect to the accuracy orcompleteness of the information, or with respect to the terms of any futureoffer of transactions conforming to the terms hereof. Certain assumptions may have been made in theanalysis which resulted in any information and returns/results detailed herein.No representation is made that anyresults/returns indicated will be achieved or that all assumptions in achievingthese returns have been considered or stated. Additional information is available onrequest. Opinions and estimates offeredconstitute our judgment and are subject to change without notice, as arestatements of financial market trends, which are based on market conditions. Unless otherwise indicated, figures presentedare preliminary, unaudited, subject to change and do not constitute Dalton’sstandard books and records.

Please note that neither theFunds/Composites nor the Investment Manager/Investment Advisor complies withthe requirements of the Alternative Investment Fund Managers Directive(“AIFMD”) of the European Union. No direct or indirect offering or placement ofshares by or on behalf of the Funds/Composites or the Investment Manager may bemade to or with investors in member states of the European Union in breach ofeither the applicable requirements under the AIFMD or the private placementregime in each relevant member state.