Jack Nelson: ‘Investing in Emerging Markets Should Primarily Be About Analyzing Individual Businesses’

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Our guest this week is Jack Nelson. Jack is lead manager of the Stewart Investors’ Global Emerging Markets Leaders Sustainability strategy, which is highly regarded by Morningstar’s manager research team. Jack joined Stewart in Edinburgh, Scotland, in 2011 after obtaining an MA from Oxford.

Background

Bio

Stewart Investors

Emerging Markets

“Global Emerging Markets Sustainability Strategies Update,” Q&A With Jack Nelson, stewartinvestors.com, April 2023.

“Finding Resilient Businesses in Emerging Markets Is Key to Long-Term Success,” by Jack Nelson, trustnet.com, Dec. 15, 2022.

“Stewart Investors’ Global Emerging Markets Sustainability Strategy Marks 15-Year Anniversary With Benchmark-Beating Returns,” prnewswire.com, May 7, 2024.

“Go Beyond the Data to Find Quality Sustainable Investments in Emerging Markets,” by Jack Nelson, investordaily.com, July 16, 2024.

“Stewart Investors Launches EMs ex-China Sustainability Fund,” by Natalie Kenway, portfolio-adviser.com, July 11, 2024.

Artificial Intelligence

“Am I Invested in AI?” stewartinvestors.com, Aug. 4, 2024.

“A + I Equals More Than NVDA,” stewartinvestors.com, March 27, 2024.

Other

The Rise and Fall of American Growth: The US Standard of Living Since the Civil War, by Robert Gordon

Inovance

Yifeng Pharmacy Chain Co Ltd

Samsung Electronics

“Unilever’s India Unit to Rebrand ‘Fair & Lovely’ to ‘Grow & Lovely,’” reuters.com, July 2, 2020.

Principles for Responsible Investing

Delta Electronics

Transcript

(Please stay tuned for important disclosure information at the conclusion of this episode.)

Dan Lefkovitz: Hi, and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes.

Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.

Lefkovitz: Our guest this week is Jack Nelson. Jack is lead manager of the Stewart Investors’ Global Emerging Markets Leaders Sustainability strategy, which is highly regarded by Morningstar’s manager research team. Jack joined Stewart in Edinburgh, Scotland in 2011 after obtaining an MA from Oxford.

Jack, thanks so much for joining us on The Long View.

Jack Nelson: Thanks Dan and Christine. Thanks for having me.

Lefkovitz: Absolutely. Well, we wanted to start off by asking you a little bit about your journey. How did you come to be an emerging-markets equity investor for Stewart in Edinburgh?

Nelson: I think like most people, an idiosyncratic path. To be honest, the bug for emerging markets really bit me at quite a young age. I was very fortunate. When I was studying, I managed to get onto a government program here in the UK, run by our cultural international arm of the British Council. And they sent around 100 teenagers to India, China, and Brazil. This was around the peak of the last great bull market. So, this was 2007-08. And I managed to spend a few months in India and just got bitten by the bug of emerging markets—the energy, the dynamism, the sense that people were very rapidly moving up the quality of living standards that you see in emerging markets, and certainly, saw that time.

Coming back from that experience, I used to tailor my further education at Oxford around China, India, development economics. And then I didn’t really have an idea to be honest of how I would use this interest in a way that would be employable. And I was super lucky to come across a role with Stewart back in 2010, 2011, specifically as an emerging-markets Asia analysts. And so, that was from then on, the only job I wanted was lucky enough to manage to join a small team with a bunch of fantastic investors on it at the time—Angus Tulloch, Jon Asante, David Gait, who’s my boss today—and get involved at a relatively early age with the emerging-markets funds that I’m now involved in running.

So, it’s one of these things that I think once you start to think about emerging markets at that point and you become bitten by that bug, it’s very hard to imagine yourself doing any other sort of area of finance. And for me, the nexus of that and the epitome of it is this idea that we’re living through a big one-time leap in living standards for a huge portion of the world’s population. There’s this great book called The Rise and Fall of American Growth by a guy called Robert Gordon. It basically outlines how for the 100-year period from 1870 to 1970 you went from this situation where most Americans didn’t have running water, access to medicine, education, indoor heating and plumbing. And then, 100 years later, life expectancy is decades longer. Everybody’s got these immunities and there haven’t been that much technological change since in day-to-day life. That’s what we’re going through in emerging markets right now. In a compressed period, it won’t take 100 years. But in a way, it’s the biggest story in world history, if you think about it in those terms in terms of the living standards of the majority of people on the planet. So, once you start thinking about that in depth, it’s very hard to imagine yourself wanting to do anything else aside from emerging markets and investing in that story.

Benz: We know there’s a lively asset-management community in Edinburgh, but is it challenging to invest in emerging-markets-based companies from there? Can you talk about the logistics of researching companies from your current location?

Nelson: Yeah, I think the UK is in a pretty advantageous situation in terms of managing emerging-markets funds. And I have done this from Sydney, Australia, as well, which I’ll tell you is a little bit harder. You certainly get far fewer corporates traveling through Sydney, given the slight peripheral location on the globe that it is. In the UK, we’ve got that proximity to London, obviously, which gives us a great ability to meet with corporates in Edinburgh. We’re also blessed by the fact that the city itself is steeped in history with funds management and obviously, still today has a great number of fantastic fund managers. And so, we’ve always benefited, and we continue to benefit and contribute to that community, which does give us a fair amount of corporate access.

There’s also this point I’d probably add, which is that to my mind, if you think about where your competitive advantage comes from in funds management, there probably isn’t a huge advantage to knowing more than the market. Information is ubiquitous. There’s no advantage to being faster than anybody else. And so, you can arguably instead posit your behavioral advantage on behavior. And in that way, being slightly apart from the noise away from places like London or New York, we’ve always tried to make a virtue of in terms of being able to step back, be a bit more long term and switch off the noise from the sell side and the impulse to trade more often than perhaps we should. So, in that way, Edinburgh can be slightly advantageous from a long-term investor’s perspective.

Lefkovitz: You referenced traveling to some emerging markets in the early 2000s when the asset class emerging-markets equities was booming and the BRIC acronym—Brazil, Russia, India, and China—was very hot. Emerging markets has obviously been a much more challenging place to invest since then. Has there ever been a feeling of like you missed the boom times?

Nelson: Yeah, my timing has been pretty poor in terms of when I joined the industry and started investing in emerging markets. But I think if we think about the long-term relative performance of emerging markets, we’re all probably prisoners of recent history. The question around emerging-markets’ performance is usually couched in terms of the last 10 years or last 15 years or so versus the period before that. And perhaps, it’s probably pertinent to step back and think, actually, that period 2002 to let’s call it 2010 roughly, probably was the exception to the rule rather than the norm. We’re probably still prisoners of that BRIC acronym mindset to a degree that actually emerging markets just have to get back to where they were, this top-down idea that everybody in China just bought a few more pens and you’d have all these companies that could benefit from that, and it would be very easy to make lots of money. And of course, we know from financial history, there’s very little correlation between economic growth and stock market returns. And so, it’s always really been about the corporates that we’re invested in rather than the top-down picture. And so, whilst the last 15 years have been difficult, it certainly has been eminently possible to deliver attractive returns if you’ve been in the right companies in emerging markets over that time.

Benz: You mentioned that there’s a weak correlation between economic growth and returns. How about valuations? Because valuations for emerging markets are far lower than they are for developed equities, especially US developed equities. So why haven’t lower valuations been a catalyst for emerging markets? And to what extent is there what seems to be kind of a persistent discount justified?

Nelson: Well, I think we’ve seen more and more justifiable reasons for that discount. So obviously geopolitics has played a huge role here, whether that’d be in China, Russia, or elsewhere in the asset class. And so, I think it’s easy for you to post hoc rationalize the discount. I get the sense as well, speaking to clients, that people just feel like they’ve heard this story before. They’ve heard this argument about the valuation discount between the US in particular and emerging-markets assets for 10 years now. And it’s been wrong repeatedly for a long time. So, I think people are becoming more and more immune to that argument over time.

And particularly for US-based investors, every country has its home country bias. But when I travel to the US and meet with consultants and clients, I get this distinct impression that for American investors, there’s a sense of, the rest of the world looks quite scary from where we’re sitting; given what’s going on in the rest of the world, the best corporates are here, why bother. I think maybe making the argument in valuation terms is partly doing the asset class an injustice because yes, valuation discounts are at a very high level compared with history. But ultimately, in the long run, it’s actually earnings growth that’s going to drive returns. We all know that over longer periods of time, it’s compounding of earnings per share that’s going to drive individual stock returns and indeed the whole asset class.

So, I’d rather argue for all emerging markets as an allocation and as an asset class, less so on the valuation discount, which is relevant but a smaller part of it. But based on that fact that actually within the very diverse set of companies which make up emerging markets, there are some fantastic companies and there’s plenty of opportunities within that tens of thousands of listed corporates to find brilliant companies that can deliver exceptional compounding of earnings per share. It’s just that the index in particular has not been a particularly good way of investing in that and getting that opportunity.

And I’m talking my own book, of course, as an active manager, but I’d argue that because in emerging markets you do have a really huge diversity in quality from the very worst companies in the world through to the very best in my opinion, a passive approach will inevitably come up short in terms of trying to distinguish and make some judgments around that. And if you look at the top 10 constituents of the index historically over the period that we’re talking about of underperformance, we are talking about Petrobras, Gazprom, China Mobile, Vale, ICBC—big Chinese state-owned, the Russian state-owned companies, which understandably haven’t been exceptional performers. But if you were to look at that from a bottom-up perspective, at any period, you would have perhaps thought that that would have been something which you might have expected—you might have thought that actually perhaps state-owned Chinese companies would not have foreign shareholders’ equity returns as their number one priority. So, it has been possible to deliver good returns by being much more bottom-up and looking at individual corporates and treating the asset class as a collection of very diverse corporates rather than a monolithic block in a macroeconomic concept.

Lefkovitz: I’ll ask you another question that allows you to talk your own book. Why do you think that emerging-markets equities should be a stand-alone allocation as opposed to part of a broad global equities portfolio or from a US perspective, international equities ex-US?

Nelson: We have seen the rise of this phenomenon, not just because of the relative performance, but also because of the success of particularly American, but also European and Japanese corporates in growing their businesses in emerging markets. And as we do also run global equity products, we certainly spend a lot of time thinking about this phenomenon in that context.

I would probably argue, though, that emerging markets justifies its existence simply because of the peculiarities of investing bottom-up in the asset class. Even though, as I said, the macro concept is slightly tenuous and the asset class is much more diverse than perhaps people might at first glance realize from that perspective, there are commonalities to emerging markets bottom-up. So, for instance, I would argue that in a developed-markets context, the key corporate governance question is often around alignment. It’s often around how do we incentivize these executives to put shareholders’ interests first? And whenever we read US annual reports and go through the remuneration section, it often blows us away how complex and convoluted and well-thought through in some regards, but also overly engineered, the remuneration packages that these corporates often put in place are in order to try and tackle this governance challenge, which is that they’re not run by people who otherwise have skin in the game.

In emerging markets, we’re in a different position. A lot of the companies we look at are controlled or owned by someone or something. So, with the aforementioned companies where it’s state-owned businesses that have been large constituents of the index, the key question has not been around incentivizing private individuals who are here for their options package and will be gone in a few years. It’s around what does the government want from this state-owned company over time? Equally, if you’re investing with families in emerging markets, which makes up quite a large portion of our asset class because those founding families often have held onto their shares a long time, haven’t moved away from the business over generations, as has been the case in developed markets, you end up spending a lot of time thinking about what are the right approaches to family companies’ corporate governance. And those nuances I think aren’t necessarily replicated throughout global equities to the same extent. And so, you do have some degree of a particular approach, which works, I think, in emerging markets, which perhaps your global investing mindset might not quite capture if you were looking at this purely through the lens of will you gain sufficient access through Visa or Microsoft.

Benz: You’ve written that top-down factors cannot make an investment case, but they can break one. What do you mean by that? And perhaps you can share an example or two to illustrate.

Nelson: Absolutely. So, I think this just comes back to this idea that actually investing in emerging markets should primarily be about analyzing individual businesses rather than currencies, politics, exchange rates. Of course, that’s important. Of course, it needs to be considered. But in our view, it’s probably the last thing you consider.

There are tens of thousands of listed companies in emerging markets, and our view would be that actually probably 90%-plus are not worthy of investment or consideration for investment because of flaws in quality, usually relating to people and ownership, but also the balance sheet, the business model, the positioning with regards to sustainable development, which we think is very important over the long run. And so, in that context, when you’re trying to focus on the best companies, first and foremost, it would be a very inefficient use of time to spend the first, second, and third step of your investment case trying to find macroeconomic reasons to own an individual stock. That is an important backdrop consideration. But I think first and foremost, we need to think about whether the corporate we’re looking at in particular does have the capability to deliver compound earnings growth, which is going to be able to deliver excess returns. We then do need to consider of course alongside valuation, the macroeconomics and the politics.

So, what that means for us is that we never sit down and say, “Hey, we think that the South African rand is going to do x, y, and z. Let’s go and find a company which is going to benefit from it.” That’s a very risky approach. I think it’s very dangerous because you start to spend a lot of time trying to analyze things, which are almost impossible to analyze, not just because they are very complicated, but also they depend on the whims of individuals. This raises its head particularly in more autocratic countries. And so, a good example of this would be Turkey. We’ve not had anything invested in Turkey for quite a number of years now because we go there, we meet companies. I was there in April this year in Istanbul. There are some fantastic corporates in Istanbul and Turkey managed very well. But when you come away from that, and the final piece of the investment case jigsaw puzzle is, what is the interest rate going to be? What’s the currency going to be in five years when we’re looking to sell this stock to realize the hopeful gain? And you have no real idea of how to calculate that number. Well, that’s where I guess the investment case can fall down.

Instead of trying to ascertain with certainty a position and work from that, I’d say it’s much easier for us to analyze individual businesses. As business analysts, that’s a bit more tangible. We can get our hands around that. And then when we feel that there’s a sufficient degree of uncertainty with regards to politics or macro, we can simply move away. We can say, OK, look, this one’s too hard and stick to companies where we feel there is a degree of predictability and resilience in the backdrop, which allows us to make that investment on behalf of clients. And there’s enough fantastic companies in emerging markets that means we can afford to do that and still retain a good number with which to invest.

Lefkovitz: Well, you mentioned challenges related to autocratic governments. This seems like a good segue to China. Stewart recently launched a Global Emerging Market Equity ex-China fund. It’s interesting how China has gone from one of the key reasons to invest in emerging markets to a market to be excluded. What prompted the launch? And you still seem to have some China exposure in your broad portfolio, though.

Nelson: Yeah, I’d say there’s a few angles to this. With honesty, the first reason to launch a GEM ex-China fund is with the view that we can’t predict the future. Geopolitics is inherently volatile and unpredictable. And there is at least some probability over the very long term that China is not a constituent of the emerging-markets asset class for various reasons. In that context, it’s incumbent on us to make sure that we have something of an insurance policy in place for that eventuality so that we have a track record in place with a GEM ex-China product. At the moment, we’re not actively and aggressively marketing our GEM ex-China capability. We’re in the phase of trying to build up the track record there. But we have run our emerging-markets strategies with very limited China exposure historically. Historically, it’s been in the single digits. And so, for many people, we probably do look a bit like a natural candidate. Even when people are allocating to emerging-markets ex-China, our track record hasn’t been built on China.

And the other element to this, I suppose, is that there’s a philosophical question here as to whether the role of a fund manager is to set out his or her stall and say, this is the way the asset class should look according to us, or the way to operate is to say, look, we understand that clients have different needs and goals, different views and perspectives, and the same way that we run a European fund, including the UK and excluding the UK, because we know that British investors might want to make separate allocations, we’re just doing exactly the same thing here. And while taking a view strictly speaking on China in having this product but saying that we understand there will be some people for whom China is an exclusion. And equally, there will be some who will be carving out China for a separate and much more meaningful allocation, depending on their own taste.

So, I think that’s fine. Both are obviously acceptable approaches. We feel that our role as fund managers and as a firm could be to offer a really competitive GEM ex-China product backed by a long track record, as I say, investing in GEM without a huge exposure to China. It doesn’t necessarily indicate a huge amount about our views on the country. As you alluded to, our exposure to China has been going up, rather than down over time.

I think if you step back and think about the context, this idea of generations of companies is probably quite pertinent. And we’ve been investing in China for a very long time. But more than 10 years ago, it probably looked a lot more like investing in Hong Kong exchange, the better state-owned companies, and those companies which were more concentrated in things like financials. Over the last 10 years, and bearing in mind, we’ve had access to the Asia market through Stock Connect for 10 years now. We’ve gained access and therefore gradually comfort with, I guess, a new generation of non-SOE, nonfinancial, non-big tech, mid-caps, I’d say, mid- and smaller large-cap names, listed primarily on the mainland, much more often founder-led rather than state-owned companies, private sector and in areas like industrial automation or biotech or advanced manufacturing and robotics, which we didn’t really have access to in previous years. And so, over the last five to 10 years, we’ve been obviously traveling to China—a lot of the was team there last week—building up our knowledge, understanding of these companies. And if you combine that with where valuations are today, we’ve been able to modestly increase our exposure to a little bit over 10% at the moment.

So, certainly, still relatively modest compared with our benchmark. In our view, the best way to beat the benchmark is to completely ignore it. And for us, China, at the moment offers a small handful of very high-quality companies that we’re comfortable with, which have allowed us to increase exposure but certainly nowhere near the 30%, 40% that we’ve seen in the benchmark in the past.

Lefkovitz: That’s really interesting. Can you provide an example just to bring that kind of space to life?

Nelson: We own a company called Shenzhen Inovance—it actually was founded just over 20 years ago by a team of engineers who upped and left Emerson Electric. So, this has been one interesting challenge investing in China. In most markets that we look at, we get quite ample opportunity to have face-to-face conversations with founders, owners, chief executives, and that’s a key part of the investment process. It’s dangerous on its own because a meeting with a founder, a very charismatic founder, can be a very vivid signal, but not always a strong one. And we have to marry it with his or her track record and third-party reference checks to try and build up that picture of the quality of people.

In China, it’s a bit different. You don’t always get that same opportunity to meet with founders. And so, if I look at some of the companies we’ve owned in the country, there is a recurring theme, not by design, but whereby we’ve invested alongside senior executives from Western multinationals who have moved on and founded their own businesses. Chinese nationals who perhaps studied in the US, ended up in a US corporate, being sent to China as the country head, and then after 20 years have decided to strike out on their own and found their own business, which is being now 20 years in existence, is listed, successful, doing very well, and taking market share from often their ex-employers.

It’s a good way of us to try and triangulate quality of people. If you’re looking at a founding team in China who, as I say, you might get to meet, if you’re very lucky, maybe once every few years rather than annually like we like to in most markets, at least you can say to yourself, look, we meet with Emerson Electric, meet with Stryker, we meet with these companies that are relevant here, and we respect them as institutions. And if they have appointed this person as head of their second largest market and entrusted that person, they clearly think he or she has huge amounts of competence and integrity. And that’s a good reference check for us as well and point of triangulation when we’re trying to put together that jigsaw puzzle piece around quality of people.

Benz: So, Jack, you mentioned GEM a couple of times. That’s global emerging markets. Is that the shorthand that you use?

Nelson: Yes.

Benz: OK, great. Sticking with China, we wanted to ask about how you’re thinking about the top-down challenges in China. Obviously, the property sector problems, weak consumption, geopolitical tensions, especially in light of the upcoming US election. Can you talk about that and how they factor into your thinking about investing in companies in China?

Nelson: It’s probably a manifestation of the earlier point that actually you do need to take into account the backdrop, but it probably shouldn’t be your first port of call in terms of your analysis. So, ideally, the companies we’re looking for in China are those which have the ability to grow earnings somewhat regardless of economic conditions. No company is completely insensitive to the broader economic picture, but there is a spectrum, and it would be much more attractive for us to invest in a company which was, let’s say, consolidating a large market and growing organically within a space due to very strong competitive advantages rather than relying on top-line growth at a sector level.

So, for instance, we own one of the larger pharmacy chain retailers in China, a company called Yifeng. If you look at developed markets, if you look at the US, those drug stores tend to become oligopolistic in the end simply because there are such strong economies of scale in that market. In China, there are hundreds of thousands of independent dispensaries and the largest players like Yifeng have 2% to 3% market share and have been growing at 15%, 20% for a long time simply by taking market share away from your less-efficient smaller chains, mom and pops. That individual stock trajectory is on one hand relatively low risk in our predictions, I think. If you were to say, what are the odds in 10 years’ time that the market share of Yifeng has gone up? I think that’s a very high probability that it’s a more concentrated market. Yes, it’s very, very likely. We’ve seen that in other markets in South Africa and Brazil where we own pharmacy chains. So, you don’t have to make specific predictions around macro. And this phenomenon will happen regardless of whether GDP growth is 3%, 4%, 5%, or 7%.

So, it’s another reason to look at smaller mid-cap names in China rather than the headline banks and tech companies, which are proxies on GDP and broader consumption. Because if you feel that China—don’t have a view, you want to head elsewhere, but clearly there are lots of headwinds to consumption and to growth in China, certainly makes a lot more sense to step away from what the index tells you is the best opportunities in China, which are the largest companies, look for the earlier-stage, slightly smaller companies, which are a little bit more able to grow without recourse to particular GDP outcomes.

In that context, for us, it’s a simple sense of trying to say, which sectors of the economy are able to do that and which areas are not? And there is an extra layer in China, which I think makes it a particularly challenging place to invest and a dangerous place for capital, which is that not only do you have an economic model which is built upon low cost of capital and state-directed lending, which historically has led to fierce competition in many markets and therefore low return on equity, which has over time correlated and led to disappointing equity returns for shareholders. You also have, of course, the added layer of policy and regulation and trying to understand, broadly speaking, where does the party’s wishes sit with regards to this particular business?

And so, I think it’s an area which, much like trying to predict macroeconomics or which way that the new government of XYZ country is going to go, to think about what does the government want specifically from a particular sector? But we can try and make broad predictions with regards to pharmacy chains, for instance. It seems highly likely that over time the government will feel that consolidation is a good thing. For various reasons, it means people pay tax, it means less fraud, it means lower cost of drugs for people, because they can pass on those gains. It’d be easier to regulate five big chains than 100,000 tiny ones. And so, the government, we feel, will be supportive in that case.

Investing in China from a sector perspective looks at least as much about trying to be sensible around these sorts of ideas as the macroeconomy. And so, for instance, in healthcare, we’ve over time, I’d say, evolved our views on the healthcare space. Three or four years ago, we had quite a number of companies in that area in China. And over time, we’ve exited most of them simply because it’s become apparent that actually making what you would consider an attractive margin or return on equity in that space in China is just likely to attract regulation. And so, the opportunities for that compound of earnings over time seems pretty limited. And so, it’s a sector which therefore becomes more difficult. So, there are a few rules of thumb we can use—sectors which are apolitical, more often B2B, but not always; mid-cap rather than mega-cap, which hopefully is below the radar. These are some of the ways we try and approach the challenge of investing in China, which hopefully mitigates some of the most obvious risks, which is that the government decides that the sector or the company in question should no longer make the returns that it’s been making.

Lefkovitz: Jack, wanted to take a step back and ask about the sustainability aspect of your approach. You referenced sustainable development earlier. Is there anything about the emerging-markets context that makes environmental, social, and governance screens more challenging or more important to consider?

Nelson: Yeah, absolutely, I would argue so. It comes back to that introduction and that idea about this one-time leap in living standards in part, but also the parallel, which is that that leap in living standards is being accompanied by the great challenges which go with that—taking the US from living standards of 1870 to 1970, even when done over 100 years wasn’t an easy process. It didn’t come without its challenges in terms of pollution, social issues, and so on.

And so, the way we would posit it is that it almost doesn’t matter which issue you look at. If you think about air quality, soil erosion, deforestation, conflict minerals, gender inequality, social opportunity, even we’re getting into things like diabetes and obesity, the epicenter of them actually is all in emerging markets. We’ve all seen these statistics that 90% of the plastic in the oceans comes from 10 rivers in Asia and Africa. So as important as it is that we tackle these challenges in the developed world, actually the make or break for most of these issues will be in emerging markets. So not only that, in terms of the impact that emerging-markets companies and countries have, of course, also emerging markets will bear the brunt of challenges, particularly climate change. The way we think about climate change as a risk and opportunity for emerging markets is very much in the context that actually the floods, the typhoons, the droughts will be affecting the consumers that are buying the products of the companies we invest in. So, we’re inherently aligned with policies which stand to improve practices on that topic and that issue, because ultimately, it’s in our own and our clients’ interest in the emerging markets prosper and that involves having a climate that’s livable for the billions of people in the emerging markets.

So, I’d say for those reasons, when we look at individual companies, it’s pretty important that we consider those factors pretty high up the list. Again, it’s very straightforward and sensible when you step back and get away from the financial industry and the way we sometimes are led to think about things. We use a basic framework of thinking about headwinds and tailwinds and asking the question: If the world is going to move over time toward a situation where people have enough and we are living within resource constraints, how is this company positioned? And that means that inevitably and inherently we will find investing in companies that have business models reliant on overconsumption and essentially ecological degradation we will struggle with simply because we feel the high risk. Our average holding period is in excess of six years, our turnover is 15%. And there’s plenty of stock we’ve held for 10 or 20 years in our portfolios today. So, the time horizons we’re talking about, these issues really matter. If we were turning the portfolio over every 12 months, then it really wouldn’t matter whether the mortgage lenders that we invest in have loaned to property which will be flooded. But actually, if we’re owning that stock, as we have in that case for 25 years, that’s really material as a financial issue. So, it’s incorporated for that very simple purpose. It has been for the whole time that we’ve been doing this.

So, our funds have been running this exact same way from 2009. We’ve not come on this in the last few years, as it’s become much more popular. We probably, I think, have the oldest Asia and emerging-markets sustainability funds in the world and quite proud of being able to have done that for quite so much time.

And lastly, in terms of that final point, it’s something we’ve referenced already, but simply the centrality of governance. I’d say the genesis of Stewart’s investors, if you go back in history, goes back to the 1980s, and our founder, Angus Tulloch, who was running around Hong Kong and Singapore, and quite quickly realized that if you’re investing with taipans and oligarchs in Southeast Asia, who you’re investing alongside is the most important question. If you were going to invest personally in a small business, you would spend a huge amount of time analyzing the ethics, the integrity, the competency, alignment of your business partner if you were putting your own money to open a store or a small business. And yet when we hand over sometimes millions of dollars of clients’ capital, we spend less time on people. We think it’s all about simply running numbers. But actually, the most important question is who you are investing alongside. And in emerging markets, that governance aspect is particularly prominent for obvious reasons. We don’t have necessarily all the same protections because of essentially institutional corruption across the world. And it’s important that we try and navigate those challenges with a very keen focus on investing with the right people because there’s no faster way of losing clients’ capital than getting the people analysis wrong.

Benz: We wanted to home in on that governance piece a little bit more. Our manager research colleagues tell us that you and your team have traditionally shied away from South Korean stocks because of corporate governance concerns. But we noticed that Samsung Electronics has been in the portfolio for about a year now. So maybe you can talk about how you gained comfort, how your analysis of the governance and the people at the firm gave you comfort being invested there?

Nelson: Samsung is an interesting case study of governance evolution. I’d say if you went back in history, there have been plenty of examples of the group in the broad sense, while certainly being very, very competent and aligned with shareholders, particularly at the top of the corporate structure, have cut corners in various places. And historically, we have found it quite difficult to invest with the group in the last, I’d say, five to 10 years because of that. In particular, the former chairman—listeners who aren’t familiar with this case—was arrested and sent to jail, essentially for corruption, for trying to avoid a very large inheritance tax bill, which Korea has in place. So, you have 50% inheritance tax. So, essentially when his father died, he would have to hand over half the family wealth. Our interpretation is that Jay Y. Lee, the person in question, overreached, attempted to subvert the political process in Korea, failed to do so. Korean Democracy won, he went to jail, and he then had to step back quite materially from the company.

So, when we were analyzing this at the time, this was five years ago or so, it was pretty unthinkable that you wouldn’t have a family member on the board or chairing the company. They historically controlled it quite tightly, but as a consequence of overreaching and having corporate governance blow up in their faces, the family essentially have had to move away. And we see this in many cases, both in developed and emerging markets. You often have the second or third generation get to a point where the business is simply too big, too complicated, and over time, management is professionalized, and maybe they gradually move to one board seat and then become more and more passive over time. So, I think our analysis would be that the family having suddenly had a Damascene conversion to top class corporate governance, but actually they have a much more limited ability to harm minorities now compared with the past because of that lack of influence that they have relative to the past.

There’s also an important context to consider as well, which is that Korea has somewhat looked across the Sea of Japan and looked at its eastern neighbor and the attempt that Japan has made to increase ROEs, unwind crossholding structures, and improve stock market valuations with some success and tried to replicate that. So there definitely is this push in South Korea to unwind some of the circular shareholdings within the tables to cancel Treasury shares, start paying dividends, have a clear cash return policy, separate the CEO and the chair role, introduce foreigners to the board and to the executive team, and have the family step away a little bit. And all that’s happened at Samsung in the last few years. So, you are somewhat, I’d say, protected to an extent from corporate governance mishap from the family because corporate governance abuse at Samsung Electronics, at Korea’s flagship company, would be a terrible message for global investors about investing in South Korea. And I suspect the government would take a very dim view of that. And so, you’re quite likely, I’d argue, to have a sort of check and balance in that regard from the regulator now compared with in the past when this was far less of a focus for the regulator and for the government and where the family were much more prominent in running the company. So, for the combination of reasons there plus what’s related to the business itself, where we are in the cycle for memory and valuations, as you say, we’ve had Samsung Electronics back in the portfolios across the board for the last short while.

Lefkovitz: We know that at Stewart you do engage with the companies that you own. And some of this engagement, of course, revolves around environmental, social, and governance type issues. Can you give us an example of how that works, that process works?

Nelson: The process around engagement does have a range of forms, I would say. We meet with companies hundreds and hundreds of times a year as a team. And in most of those meetings, there will be something that you probably could call engagement. It could simply be asking them why a certain person sits on the board when they don’t really look like a true independent, or talking to them about an accounting policy that we feel is slightly aggressive. And so, in that context, engagement is continuous, small scale, and ad hoc in the basis that for every company we own, there are things we want to improve. And every time we meet them, we will raise them.

Beyond that, there is probably a second step, which is much more formal engagement, which takes the form of direct, formal communication to boards of directors on strategic issues. So, for instance, one of the challenges we have in emerging markets is that we don’t get the same degree of environmental data that we do in developed markets. So, every single company that we own, which does not have carbon disclosure or a carbon target, have been engaged with in a formal way, we haven’t necessarily had a positive response from every single corporate because some in emerging markets are culturally, as you can imagine, slightly closed to this sort of engagement sometimes. But equally, we’ve certainly had success through this sort of engagement.

Those sorts of topical big-picture issues often take a lot of time. One of the key lessons with engagement is that you do have to be persistent. You do have to give the company the impression that you’re not going to go away. You do have to do things respectfully and do it based on relationships. Ultimately, as fund managers, as analysts, we meet with the individuals, the CFO, the CEO, the IR at the corporates we invest in repeatedly over our careers. And we build a degree of rapport with them. That means that we can pick up the phone and have conversations and we can do things in a way which saves space to a degree. We are investing in cultures where doing things publicly sometimes isn’t always the best way. And having more discrete conversations can sometimes be the best way.

We’ve also found, I’d say, with engagement that often trying to frame the conversation as a way to benefit the corporate, frankly, is the best way. You sometimes feel like you’re pushing on a closed door, a locked door, where you fail to convince the corporate that your suggestion or your ask is in their own interest. So, a good example here was we engaged with Unilever for a long time on a product they had in India called Fair & Lovely, which is essentially a skin bleaching product. So, this was a product marketed to lighten your skin tone. And the marketing, the advertising around it was particularly egregious, you’d say, in terms of the purported outcomes that this product would give you. And we wrote to them, we stood up at their investor day and slightly embarrassed the CFO. Last time we wrote to them was myself, to the chairman. And they more or less ignored us on the basis that this was a very profitable product. They simply defended it on the basis that it’s what the consumer wants, we’re simply fulfilling their desire. And it completely blew up in their faces during Black Lives Matter. And the argument we’ve been trying to make to them for 10 years, which was you’re risking the entire Unilever stable of brands globally from a reputational perspective based on this one product in India, which is so not fit for purpose, that it’s so obvious to anybody who ever hears about it. Surely the long-term decision here is to move away from it. So that was an unsuccessful engagement. They changed in the end, but only when society sort of made them do it in a broader sense. And maybe we contributed in a small way, but I wouldn’t chalk it up as a success.

The last and final—sorry, this is the long answer—the last and final form of engagement is more strategic and across a particular issue with many corporates. So, at the moment, we’ve got an ongoing strategic engagement on conflict minerals. My colleague Chris McGoldrick has been spearheading really the drive here to engage with semiconductor companies and technology businesses who don’t have a huge understanding or desire to understand, I’d say, the supply chains that they have around minerals in their products from Central Africa, mined in illegal ways, and with pretty dire environmental and labor abuses going on. It all started from a conversation with TSMC where you asked them a bunch of questions on carbon and water, and they’ve got lots and lots to say on that. But you asked them about where do the minerals come from and they just don’t know.

It feels very similar to palm oil 20 years ago. You asked consumer companies in Asia where palm oil supply chains were based and what the practices were, they didn’t really have a clue 20 years ago. And now we’ve moved forward quite a lot. We’ve got lots of certification and more transparency in that supply chain. Hopefully, that’s where we’ll get to in electronics as well. But in the meantime, we’ve used the UN PRI platform. We’ve had lots and lots of investors sign our initiative there. That’s gained us access to top level executives with a lot of the big US tech firms as well as the Taiwanese. That will again be a multiyear engagement. It’ll be something we’ll keep doing for hopefully the foreseeable future. And if we can make a small improvement to the corporate practices, it’ll mean the companies we invest in are lower-risk, higher-return, and ultimately, it’s in the benefit of our clients, we believe.

Benz: Sticking with those technology companies, it wouldn’t be a podcast these days if we didn’t ask about AI and its influence in your thinking about the portfolio. The Global Emerging Markets Leaders portfolio has roughly 40% exposure in information technology companies as of July 2024. And that’s much higher than the benchmark. Can you talk about how much of that has to do with AI and how you’re thinking about that as a trend as you’re putting together your portfolios?

Nelson: Because we are quite low turnover, as I say, we haven’t really, I’d say, rotated into any companies as a consequence of AI. And in fact, if you went through the history of financial markets, you would probably find a number of episodes, whether it were electric vehicles, solar power, or the great resources super cycle of 15 years ago, where there was a lot of excitement around a particular sector and that influenced indexes and benchmarks very strongly for a short period of time. We have a very significant exposure to the gig sector of technology, but it’s an extremely broad sector. It’s everything from Taiwanese and Korean semiconductors through to Indian IT service companies who are providing your back-office support. So, it’s a particularly broad set of companies, which aren’t necessarily all correlated with one another. Most companies in one way or another could be impacted by artificial intelligence, if indeed it does fulfill its potential.

The impact on portfolios, it’s typically for these sorts of trends and thematic ideas. Often the more attractive part of the value chain for us is what we refer to as picks and shovels companies. So, this is the idea that if you were trying to make money investing in California in the 1850s, it would be quite difficult to pick which company would strike gold, which prospector would pick the right spot and would become a millionaire. But if you were selling picks and shovels to the miners, you didn’t really have to make that decision. You didn’t have to decide whether Nvidia’s margins are sustainable or whether the valuations make any sense. And in the emerging markets, and particularly Asia, we have lots of opportunities to own the analogies of those picks and shovels.

So, one company which we do have in the portfolio, and we have had for a very long time is a company in Taiwan called Delta Electronics. And we’ve seen it evolve over long periods of time. It used to make primarily the inverters that are your power pack for your laptop, the small box you have from the wall to the device, essentially changing the current and passive components, which are quite low tech. And it’s done a fantastic job over time of evolving, building S-curves on top of the past ones. And one of the big drivers today is it’s the main power supply provider for Nvidia’s servers. It’s got a massive market share globally in the relevant cooling equipment. And it’s a good example of a company which will benefit from AI spending without necessarily being on the front cover of the FT one in every five days. So those companies often are where you do find, I think, more defensible franchises, areas where margins perhaps can sustain, slightly less glamorous, slightly more technical, slightly more below the radar, and a little more agnostic, as I say, to who wins, and which sort of AI company actually comes out on top.

It’s important for us to think about AI not just as an opportunity there, but also risk, of course. And there’s probably different levels to that. One is at a corporate level, and one is at the broader, macro level of emerging markets. The most obvious set of companies, I’d say we own, where we think about it as both opportunity and risk, is probably those IT service companies we talked about, the likes of your Infosys or your Tata Consultancy, who are employing at the moment hundreds of thousands of people primarily in India to keep the IT systems of Bank of America or American Airlines up and running. How they will be affected by AI is still to be determined. It clearly could be an opportunity in the sense that automating a lot of the more simple work that they do and capturing the data across clients that they have could put them in fantastic opportunities to offer more tools to clients. It’s also the case that these companies are in the business of change. As corporates demand AI applications, they will be developing them. But clearly, there is a risk there, which is that if AI can do a lot of the work that these IT service companies do without needing those hundreds of thousands of individuals in emerging markets, then that clearly is a disruption risk as well. So, it’s something we’re actively talking to about whenever we speak to them. And we’re lucky enough to have long-standing good relations with them and are able to have those conversations fairly regularly. It’s something which we monitor on an ongoing basis.

Lefkovitz: Jack, Stewart has developed a Hippocratic oath that all members of the investment team sign to pledge to uphold the principle of stewardship. How does it affect you on a day-to-day basis?

Nelson: So this is a credo that the founder of our team, David Gait, and I would say my boss created around 15 years ago. It’s essentially a set of principles which says that I promise to remember that I’m taking real people’s hard-earned savings and deploying it into real businesses. It is very easy in this job, I think, if you’re not careful to become slightly detached from reality to start referring to companies by the stock market tickers and start thinking of it as some sort of game to be played. It really is something that we try and keep central to our culture to remind everyone that actually we’ve got a huge responsibility. Our name, Stewart, is old Scots for steward, which obviously means to take something, look after it, treat it as something precious, and try and pass it on. And that’s the way I think we work on multiple levels. It’s how we think about client capital, it’s how we think about the firm and its culture, and it’s also often what we look for in the managers we seek to identify in the listed equities that we look for. So essentially, it’s a reminder to us all every day, everyone who joins the firm has to sign it. And there’s a framed signed version on the wall in Edinburgh, which is our historic home and headquarters to make sure we are being honest with ourselves about what we’re doing, we’re sharing our mistakes, we’re putting the team before individuals. We’re not a firm that raises individual fund managers up to high status. We fundamentally believe that the returns we can and have generated are based on a team-based approach, which is based on a particular behavioral way of doing things.

It keeps us hopefully slightly more humble than we otherwise would be and keeps us focused on being cautious, mindful of our role in society and our duties to clients being far ahead of our own interests. There’s always a challenge with any business, but probably particularly fund management, that there can be tensions between the interests of the fund manager and the interests of the client. That can take the form of managers prioritizing minimization of career risk through tracking a benchmark. It can take the form of asset gathering through raising fund size to a point which compromises performance. And we’ve been particularly focused, I would say historically, on making sure we don’t allow any of those challenges to cloud our focus on client return, which is ultimately why we’re here, why we have the privilege of doing this job, and looking after people’s hard-earned money. So, keeping that foremost in our mind hopefully just grounds us, brings us back to those ideas, make sure we don’t get lost in the noise of financial markets every day.

Lefkovitz: Well, Jack, that seems like a good place to end. Thank you so much for your time. This has been great.

Nelson: Thank you. Appreciate it. It’s been a wonderful conversation and thanks for having me.

Benz: Thank you so much for being here. This has been terrific.

Lefkovitz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow me on socials at Dan Lefkovitz on LinkedIn.

Benz: And @Christine_Benz on X or Christine Benz on LinkedIn.

Lefkovitz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

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