Despite huge shifts in the nature of emerging markets (EM) over recent decades, bottom-up research - factoring in ESG - and long-term local knowledge remain essential for investors, according to Devan Kaloo, head of global emerging markets at abrdn, whose career has spanned nearly 30 years in EM.

That period has seen vast changes: the rise of China and India to economic powerhouses, the shift from commodity to tech, consumer and renewable plays, and a sea change at company level from SOEs and founder-led corporate cultures to more shareholder-friendly approaches.

Nevertheless, risks still remain. One obvious near-term headwind is these markets’ sensitivity to US interest rates. With the Fed now in tightening mode, higher cost of capital could see emerging economies slowing and foreign investment declining.

Another headwind, Kaloo said, is widespread misunderstanding of China as an investment market. ‘People seem surprised that China is not a one way bet. The rise of new economy names like Tencent and Alibaba have drawn in a wave of new investors, and they’re not all familiar with the Chinese system of governance and how things are done. As a result, many have been surprised at the speed and scope, with little consultation, that the Chinese authorities moved to implement far reaching regulatory changes, which have had a negative impact on many of the new economy business models, although the aim of the changes to encourage competition and protect the consumer and smaller companies is normally encouraged” he said.

Kaloo also highlights the volatility that can take hold in EM. “It’s not just about the Fed or what is happening in China: politics too can be an issue: the tragic events unfolding in Ukraine with the Russian invasion is an extreme example of a political decision taken that has profound impact on that country and, sometimes, globally”, he noted.

‘Absolutely do not believe company management the first time they tell you something. Double or triple-check the information’

Devan Kaloo, abrdn

The best way to protect investments from these and other risks is a focus on quality, Kaloo stressed. ‘You always regret it when you start to trade in quality for valuations,’ he said. He also pointed to the importance of due diligence: ‘Absolutely do not believe company management the first time they tell you something. Double or triple-check the information.’

It’s also important not to fall in love with companies. ‘Sometimes you meet company management and think they’re fantastic, and there’s always a risk that your analysis becomes less critical. You need to be able to manage that. At abrdn we rely on our team approach and a challenge process to stop this happening,’ he said.

This all leads back to the importance of the fundamental research and analysis that underpins the entire abrdn approach. ‘What we mean by that is actually getting out there to see the companies: that first-hand knowledge, meeting the companies, knowing how they operate and understanding local conditions is really important because at the end of the day, you’re investing in people when you invest in a company. It’s really important that you know the people,’ he said.

Kaloo also stresses the importance of experience. ‘I started covering emerging markets in 1994. I think I’m now on to my eighth crisis, and during at least three of those crises people said they would never invest in emerging markets again. Weathering these storms certainly gives some resilience, the ability to retain perspective and not panic,’ he said.

While ESG is seen as a relatively new development across the industry, Kaloo’s team has embedded ESG criteria for decades. ‘For every company they research, our analysts provide an ESG view, explaining how they rate the company from an ESG perspective. We supplement that with a quantitative view, based on internal scoring as well as access to external providers like MSCI,’ he said.

While that process is embedded in all of abrdn’s EM funds, Kaloo also noted that the company runs sustainable development funds – essentially impact funds- that focus on areas aligned to the seventeen UN Sustainable Development Goals. ‘The key criteria for inclusion in these funds is that companies need to have intentionality, measurability and materiality in terms of their alignment with the pillars of the SDGs,’ he said.

In recent years, though, the global megatrend of decarbonisation has come to be a driving force in emerging markets. ‘It is very likely that companies that have poorly managed carbon footprints will be at a competitive disadvantage compared to those that manage their footprint well. We assess the historic carbon footprint of companies, and also use a tool that helps us look at the forward-looking carbon picture. That helps us asses where the risks are with various companies, and across the portfolio,’ he said.

Nevertheless, the fundamental starting point remains the role of bottom-up assessment, with ESG prospects being understood as vital to a company’s future performance. ‘It starts with the analysts taking a view on the quality of that company and the quality of that company includes the ESG criteria,’ Kaloo said.