Regnan has released its annual report on ESG Engagement and Advocacy activity throughout FY18. Increased scrutiny of corporate conduct, mostly due to the Royal Commission, saw a higher number of engagements on this longstanding theme. Climate risk remains an ongoing engagement theme with ASX200 companies, in particular, to pursue enhanced climate-related disclosures, management of energy transition risks, and acknowledgment of the physical impacts of a changing climate.
Download Regnan’s Annual Report report here:
About Regnan
Regnan – Governance Research & Engagement Pty Ltd was established in 2007 to evaluate the relationship between environmental, social and corporate governance (ESG) factors and investment value. Regnan has evolved to become a global leader in long term value, systemic risk analysis and sustainable investment advisory.
Regnan provides ESG integration, advisory and stewardship services on behalf of institutional investors including asset owners, fund managers, wealth managers, retail and investment banks to drive improved ESG performance in S&P/ASX200 listed companies. Regnan meets with directors and senior company leaders, in a constructive manner, to influence change on issues with the potential to impact value over the long term.
Regnan is also a regular contributor to the public debate on long term value and sustainability, and is an active commentator in the media and at corporate and financial industry events. Regnan also provides submissions to government and other policy makers to improve both sustainable investment and the identification of systemic risks.
Regnan’s research insights are applied to Pendal’s Sustainable, Ethical and mainstream funds where relevant, as well as enabling us to work with other institutional investors in meeting their sustainability objectives.
DISCLAIMER
This document has been prepared by Regnan Governance Research and Engagement Pty Limited (ABN 93 125 320 041), (“Regnan”) and is republished with Regnan’s permission. It is for general informational purposes only and should not be relied upon in making a decision to invest or a decision in relation to an existing investment. It has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation.
The information relates only to Regnan’s assessment, based on its research and the information available to it, of the performance of a company in relation to environmental, social and governance issues and should not be regarded as a recommendation or statement of opinion by Regnan on:
i. any other aspect of the company’s performance;
ii. the prospects of the company; or
iii. the company’s suitability or attractiveness from an investment perspective.
The views expressed in this document are exclusively those of Regnan and the information contained within is current as of the date of publication. Pendal Group is the owner of Regnan and commissioned the company to provide research and engagement services for use as inputs into the decision making processes for Pendal’s investment activities. The views of Regnan expressed in this article may differ from those held by Pendal Group.
Edge – the projecting ledge or brink, as of a cliff; the part farthest from the middle; line where something begins or ends; the verge or brink, as of a condition
During times of risk aversion prompted by tighter liquidity conditions, as geopolitical risks re-emerge and long-term trade agreements unravel, it is rational to get a sense of revulsion when stock market volatility increases with downside bias, in conjunction with a large sell-off in emerging market currencies.
The US dollar trade-weighted index is a near perfect proxy for liquidity conditions in emerging markets, which in turn impacts all underlying asset prices including equities.
The mighty US dollar carries all before it
There is now near unanimity that emerging markets are in a tough spot, after years of loose monetary policy that led to higher debt levels in several of those countries. When those debts are US dollar-denominated, it exposes the weakness and tension between capital flows, rising domestic inflation and slowing growth. The trade off, in a simplistic way of thinking about the conundrum, is that growth has to slow and savings have to be rebuilt (a current account surplus). That should be either by raising domestic interest rates or by letting the currency weaken. In some countries, like Argentina or Turkey, the measures have been drastic. In Asia, none of the countries is in that dire a state but the taint of emerging markets and increase in debt levels is the common thread.
“The challenge, as I see it, is not just over resilience of the businesses we own but also on the ravages that liquidity induced sell-offs and currency depreciation will bring to markets.” Samir Mehta
The big concern for all of us, not just in Asia, surely remains how China manages this transition of tighter liquidity and slower growth. We came close to a similar looking edge in 2015/16. At that time, too, we appeared to be on the cusp of a hard landing. I distinctly recollect the scare when an unexpected change in the way China managed its currency led to fears of a meltdown, which further exacerbated capital outflows from China. By February/March 2017, with the US dollar appreciating, equity markets sold off aggressively, and we all thought this was the moment when China paid the price for its extreme indebtedness. A pause by the US Federal Reserve in its path of raising interest rates gave us the breathing space to come back from the edge. In that moment, it looked and felt like we were standing by a dark and bleak chasm, but, in hindsight, this turned out to be just another edge.
I have no clue whether the edge that we peer at today is a real precipice. As I’ve mentioned over the past couple of months, I have certainly reduced the portfolio’s cyclicality and added names that we perceive to be very resilient businesses. The challenge, as I see it, is not just over resilience of the businesses we own but also on the ravages that liquidity induced sell-offs and currency depreciation will bring to markets. Caution prevails.
Politicians think of their own survival and that means taking action that the population likes. Nobody talks about the need for pension reform anymore, and that’s worrying.
Robson Andrade, head of the Brazilian National Industry Confederation, quoted in Bloomberg article, 29 August 2018
Regular followers of our process will know that we consider a country’s current account balance to be a key indicator to watch. That doesn’t mean that it’s the only place where deficits matter, though. There are times when the fiscal balance is the more important metric. That has been the case in the ongoing crisis in Argentina (where we have had a zero weight), but also forms the backdrop for October’s presidential election in Brazil.
Argentina is in an economic crisis. To the end of August, the MSCI Argentina price index was down 54.5% in US dollar terms, as the currency sold off despite policy interest rates being hiked to 60%. At the heart of Argentina’s problems is a huge fiscal deficit (forecast to reach 5.0% of GDP this year). The monetary system’s financing of that deficit has driven credit growth at an annualised rate of over 30%, which was great for assets until foreign investors lost confidence, at which point it wasn’t. Argentina now has to brutally tighten both monetary and fiscal policy at the same time.
This is unfortunate timing for Brazil, as it grapples with its own economic pressures, very much including the fiscal deficit. Like Argentina, Brazil has a large sovereign debt outstanding (75% of GDP, compared to Argentina’s 65% pre-crisis and an estimated 85% now), which comes with very substantial interest payments. That makes it imperative that the primary fiscal balance (i.e. before interest payments) is positive, but that is neither the case in Brazil (primary deficit 1.4% of GDP) nor Argentina (primary deficit 2.5% of GDP).
And yet from this chaos, in the next seven weeks, must come the man or woman who will rescue the Brazilian national finances from future crisis.
Brazil’s two significant additional weaknesses are intertwined. The first is its utterly unsustainable pension system. The various generous pension systems, implemented during the transition to democracy, use a pay-as-you-go model in which the current workforce is taxed to pay pension payments. This system faces collapse with an ageing population; the combined annual shortfall of the pension schemes is close to 4.5% of GDP and set to rise.
In Brazil, only a constitutional amendment can modify pension laws, because the right to retirement benefits is engraved in the 1988 Constitution. Reform is incredibly politically difficult, needing the support of three-fifths of Congress to amend the constitution, and has proved impossible for both previous governments and the current Temer administration.
The second weakness is the chaotic state of Brazilian politics: there is a presidential election in October; the incumbent seized power through a controversial impeachment of his predecessor and has a popularity rating of 5%. At the time of writing, the two most popular candidates are campaigning from a prison cell (Lula, currently banned from standing) and a hospital bed (Bolsonaro, who has just survived an assassination attempt). All the candidates have negative net preference from the voters. And yet from this chaos, in the next seven weeks, must come the man or woman who will rescue the Brazilian national finances from future crisis. It is completely unclear as to who this will be or how this will happen, but it has to happen to avert disaster.
From a market viewpoint, the election of a president who can manage reforms could ignite a powerful rally in Brazilian assets. Year-to-date, the MSCI Brazil price index has fallen 20.8% in US dollar terms, to a 12-month forward price/earnings ratio of just 10.2x. The potential for large moves up or down certainly exists. We remain cautious in the face of all this, but equally are alert for the opportunity to participate in a powerful upward move should the political environment improve.
“We haven’t seen a trade war hit emerging markets. If it does I think it will be quite specific in terms of where it hits.”
James Syme, Senior Portfolio Manager, Pendal Global Emerging Markets Opportunities Fund
Investor caution towards emerging markets has increased this year as a strengthening USD creates real challenges for a number of EM countries. This caution has accelerated more recently with trade war rumblings and Turkey’s economic flashpoint.
In this quarterly update, Senior Portfolio Manager James Syme:
– explains, using Russia, Brazil and Turkey as live examples, why active top down country selection is so important in EM
– sets out the team’s rationale for key country-level overweight and underweight positions
– discusses the role the USD and oil prices will play in driving EM performance dispersion.
Further reading:
Be a part of the world’s fastest growing economies
Fund Manager commentary for the month ended 31 August 2018 covering market reviews, Pendal fund performance and our outlook for the period ahead.
Access the monthly commentary here.
You’d be surprised how easy it is to take for granted the state of the world that you know.
You thought everything was fine, but then the GFC happened. Luckily, central banks covered up the mess with a put and plenty of liquidity.
You believed in the status quo, and then Brexit happens. Populism and nationalism have been ‘on trend’ ever since.
You never questioned the idea that global free trade is good, yet Donald Trump has started a trade war. He might just put the nail into the WTO coffin whilst he’s at it. Seismic shifts are happening right beneath our feet. Globalisation, it seems, can go no further in its current form.
Through all of this and more, China has remained the one constant. For all the talk of reform and economic transition, the recent shift towards domestic easing policies highlight that the old economic model remains dominant. This model has relied on a largely closed-economy system, with a currency that has been artificially kept weak over the last 30 years to support a flourishing manufacturing exports sector.
Cross-border capital flows have not been permitted, thus allowing the Chinese authorities fuller control over the financial system. This control has directed cheap credit to various industries from steel and cement to solar and high-speed rail. Debt-fuelled fiscal stimulus has been used to support growth at every turn.
What’s more, this model exists under a one-party socialist government. We in the West tend to view planned economies with disdain. There is a certain arrogance about governments who believe they can do a better job of allocating resources than the pure signal of market prices. The bad-debt problems now sitting with a swathe of zombie state-owned enterprises (SOEs) in China is case in point.
However, survival of the Chinese Communist Party and the political order that goes with it depends on continued economic progress, and its ability to carry the entire population along. This is a key point of difference between China and other socialist regimes such as Venezuela that have ended in suffering and demise.
Over the last 30 years, through its own poverty alleviation efforts, China has contributed as much as 70 per cent to global poverty reduction. Socialism with Chinese characteristics seems to offer a template for pragmatic implementation of the socialist agenda.
Since World War II, the US has tried to spread the liberal world order across the globe. By inviting China into the WTO, it was hoped that this spread could continue. Instead, whilst Chinese exports have hugely benefited from WTO membership, its industrial and political practices have moved even further away from liberal Western ideals.
The allure of the sheer size of the Chinese market has forced foreign firms to surrender their intellectual property. In return, they get to sell to and operate in China. Under the cover of subsidised cheap debt and de-facto protectionist policies that have limited the force of international competition on Chinese firms, ‘indigenous’ national champions have risen in various sectors across the Chinese economy (alongside many zombie companies to boot).
And if it can have its way, these continued practices to circumvent the spirit of international trade law would enable the success of its Made in China 2025 plan.
But the US has put its foot down. Among other things, Trump is viewed as the disruptor of global free trade. Tariffs and tweets are like hand grenades to him, thrown around to shake up the status quo, irrespective of how and where they land. Whilst his weapons are blunt, his motivations are widely echoed across party lines.
From China’s perspective, its industrial policies have been smart, but the US thinks they have been cheating. And if China’s rapid rise in the global pecking order is down to this type of behaviour, then Trump wants to fight fire with fire.
Theoretically, there is a high road that he could take, by engaging in the rule of law and soliciting support from its traditional allies. However, knowing that the law could never deliver any necessary punch, there really was no alternative for him than to get down and dirty with the same tactics as he’s witnessed from China.
If China’s $US3 trillion foreign reserve position is a symptom of unfair currency manipulation over the last two decades, then the least that Trump could do is talk down the US dollar. If China has been surreptitiously breaking WTO rules, then Trump will turn his back on the institution entirely. And if China has used fiscal stimulus funded by a ballooning debt stock to prop up growth and various industries, then Trump will unleash the largest fiscal package ever to be witnessed outside of times of war or recession.
Is this progress? It’s hard to recognise it as such when it spells the end of globalisation as we know it. Is this creative destruction? We will only know if these protectionist policies lead to a sustainable pick up in US industrial productivity – a tall order given that this declining trend has been impossible to turn for over a decade.
This article was first published by the Australian Financial Review on 26th August 2018.
Fund Manager commentary for the month ended 31 July 2018 covering market reviews, Pendal fund performance and our outlook for the period ahead.
Access the monthly commentary here.
Resilience: The ability to bounce or spring back into shape and position
There is always a debate in markets about what is the right price to pay for a good quality business. During this market cycle, since the 2008 lows in equity markets, businesses with growth characteristics have been rewarded with even richer multiples. Over the past nine years, with few exceptions, value as a style has remained unloved. On occasions, we did witness the value style outperforming growth (especially in times of macroeconomic stress or industry-specific worries), but that outperformance proved ephemeral. Despite an environment of reducing liquidity (central banks moderating QE) and rising interest rates, we have, so far, not seen any marked de-rating in valuation multiples for growth businesses. It is also a fair comment that in every market fewer businesses have delivered sustained growth in the face of several challenges, or are perceived to be in a position to do so.
Resilience matters
In the past few months, as I rejigged our portfolio, one big challenge I have grappled with is the high multiples for good quality businesses. Do I just buy stocks which appear to be squarely in the momentum trade, for whom valuation multiples already trade at significant premiums to the market? What if I misjudge the growth trajectory or the risks of industry disruption, currency volatility or a slowdown in the economy? In addressing those questions, the one metric I decided to re-emphasise was resilience. Every business invariably goes through challenging times. When it does, it is either the inherent resilience of the business, or the ability of management teams to deal with and engineer the requisite change, that differentiates it from more pedestrian businesses.
The unwelcome Maggi gift
One such resilient business I have added to our portfolio is Nestlé India (NI). A subsidiary of the Swiss multi-national, NI has operated in India for over a century and built upon its iconic brands in milk, nutrition, beverages, prepared dishes, chocolates and confectionery.
One of NI’s biggest sub-brands by far was and is Maggi Two-Minute Noodles. Between 2009 and 2014, NI aggressively expanded its factories to take advantage of potential growth in India. Yet, under the direction of its parent, NI shifted strategy to focus on improving margins at the expense of volume growth. It cut back on low-priced, lower margin products. That strategy may be appropriate in developed markets, but in a poor/emerging country like India, it made little sense, in my view, for NI to focus purely on enhancing margin at the expense of market share, growing the market and innovation. To an extent, that misstep by management led to lacklustre revenue growth in the past.
To add to this, in June 2015, one of the regulators in India banned NI from selling Maggi noodles due to food safety concerns. The food safety commissioner of Uttar Pradesh, the most populous state in India, claimed that a package of noodles contained seven times the permissible level of lead. Despite the fact that NI was convinced about its safety and quality record, NI decided to recall the product. All associated products, like Maggi jams, ketchups and beverages, were also badly affected, as consumers were naturally cautious. From a dominant 60-65% market share in noodles, NI’s market share almost halved overnight.
Nestle and Maggi Volumes
A fresh approach
But the brand was and remains iconic and NI had a lot at stake. Tackling the problem head on, NI appointed a new CEO, an old India hand. Under his direction, the management team and the company addressed the safety issue as a priority to regain trust. Simultaneously, it changed course and enhanced its innovation capabilities. In the subsequent couple of years, 42 new products were introduced. NI’s strategy turned 180 degrees, away from higher margins to growing volumes and market share with the help of innovation.
This new approach manifested itself in increased advertising and sale promotion spend. Just to put it in perspective, Nestlé globally has close to 2,000 brands; in India, it had just 20. India represents just 2% of global sales for Nestlé but has always remained a country that has great promise. There is an increased recognition by its parent that India needs to be run to meet the aspirations of Indian consumers; the local management team has been given the freedom to do so. Fortune favours the brave. This time around, NI has some tailwinds to aid what now seems to be a path towards sustained and highly profitable growth over the next few years.
Nestle India – EBITDA margins and ad spend
Commodity prices, particularly the ones most relevant to NI such as milk and wheat, have eased across the globe. This enables NI to take the higher costs from oil-related packaging products in its stride without feeling any pressure on margins. There is evidence of a recovery in consumer demand after two years of disruption post demonetisation and introduction of a Goods and Services Tax (GST). This nascent recovery could sustain as India heads into a general election, scheduled by May 2019 at the latest.
Milk and wheat price change
As is typical of governments when they approach elections, Prime Minister Modi’s administration has started to loosen the purse strings and hand out largesse to rural voters to appease them. As the rural economy starts to see better income growth, I do think NI will keep innovating and introduce more brands from the parent into the Indian market.
A rich valuation but consider the growth prospects
This leaves us with the question of NI’s valuation: the stock trades on a 50-52x multiple for 2019 earnings. For some, that’s a nosebleed-inducing valuation. On the face of it, that multiple does look rich. Yet I would suggest we put in perspective, looking at financials from 2013 onwards. In the past four years, NI’s revenues, earnings and earnings per share have barely budged.
Revenues, EBIT and EPS have flat-lined
There were genuine reasons for a below par performance. However, in my view, we are on the cusp of change. If the company does execute on its plans, it is quite feasible that in the next four years revenues and earnings double from where they were at the end of 2017. In what could be a turbulent period for macroeconomic reasons across the world, that kind of resilient sustained growth will deserve premium multiples. That’s why I am willing to take this positive view on Nestlé India.
Trade wars are front and centre for markets at the moment and no amount of ink is being spared writing about it. While many have tried to quantify the effects of trade wars on economic growth, it’s pretty much a waste of time as it is attempting to simplify the effect of a monumental change on the way that modern multinational corporates do business.
I am certain we are watching a key turning point in history unfold right in front of us. The way things have been done on the global stage over the last 40 years is changing at a lightning pace, as politics, diplomacy, immigration and trade relations are all in a state of transition. The dominant economic theory – commonly referred to as neoliberal economic theory – is no longer the playbook by which world leaders run their economies, and the new playback has many blank pages. This will have further significant effects on fiscal discipline and debt management as governments feel their way forward, obviously impacting economic growth and inflation. All of these factors will then have a subsequent effect on the role of the central bank, as the focus shifts from the independent and inflation targeting model that has been the status quo for the last 20 years. The rules of the game are changing.
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The [IMF] also notes that current-account imbalances are increasingly becoming concentrated among rich nations, as surpluses shrink in China and among crude exporters.
Bloomberg, 24 July 2018
Turkish President Recep Tayyip Erdogan
Followers of our process and portfolio will be aware of the respect we have for the IMF’s annual External Sector Report, which focuses on IMF staff assessments of valuations of major exchange rates. This month saw the release of the 2018 report, which is generally positive about EMDEs (Emerging Markets and Developing Economies), identifying the major and riskiest imbalances as being the various large external surpluses (Germany, Japan, the Netherlands) and deficits (UK, US) in the developed world.
However, the report does also identify undervalued emerging market currencies. The report is focused on the end of 2017, but it is possible to adjust those valuations by year-to-date moves to arrive at current estimates of currency valuation. More interestingly, these can be combined with equity market valuations to identify areas of the emerging market universe that are cheap overall. Obviously our full country process considers many other top-down factors, including business and credit cycles, monetary policy, politics and governance, but this may point to areas of opportunity.
Firstly, we have the complicated case of Turkey. After several years of being assessed as overvalued, the IMF 2018 External Sector report sees the lira as about fairly valued as at end-2017, which means it is substantially undervalued after the fall in the exchange rate year-to-date. We estimate the lira to be 9.0% undervalued as at end-June 2018 and 14.2% undervalued as at 6 August 2018*. Meanwhile, Turkish equities are priced at 5.8x forward earnings. The IMF sees Turkey as needing to “adopt a credible policy package involving growth-friendly fiscal consolidation” as well as reining in easy credit, and there is no doubt that the implementation of orthodox policies in Turkey would produce a very powerful rally in Turkish assets. However, we can see no sign that policymakers are considering such steps, and remain negative on Turkey.
Next up is Brazil, where the IMF assessed the real as 2% undervalued at the end of 2017, and subsequent weakness suggests a current undervaluation of 3.5%, while the equity market is cheap at 10.5x forward earnings. The IMF’s view is that, in Brazil, “lower-than-desirable credit, amid weak investment, pushed up current account balances, masking underlying competitiveness problems that pushed the current account in the opposite direction.” This fits with our view, and must be taken in the context of a fiscal problem that may, or may not, be addressed at the forthcoming October 2018 election (which we see as an absolutely key driver of Brazilian markets). Indeed, the IMF report notes that “fiscal consolidation [in Brazil] should be met with reforms to boost investment.” We remain cautious on Brazil but are monitoring developments around the election.
Finally, Korea. With its large external surplus, Korea has a very different profile to most emerging markets. There are a number of drivers of Korea’s undervalued currency (4.5% as at end 2017; 4.7% at present) and persistent current account surplus identified in the report. Overall, the IMF report sees Korea as having a higher-than-desired current account surplus, with the remedies involving a stronger currency and looser fiscal policy. We believe that the policies of the more left-wing Moon administration will achieve both of these aims, resulting in stronger domestic demand growth and an upward lift to returns from a stronger currency. Meanwhile, Korean equities are priced at just 7.7x forward earnings. Korea is one of our favourite markets.
We believe that both currencies and equity valuations are critical components of assessing the investment opportunity in emerging markets but, as can be seen in these three cases, one can ignore neither the political and policy environment, nor the credit and demand cycles, in emerging markets.
* The Turkish Lira fell a further ~24% against the USD from 6 to 13 August 2018.