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BMO Global Asset Management

Why responsible investing?

There is no business to be done on a dead planet.David Ross Brower

Only 15% of the world lives in developed countries, yet these countries represent over 40% of the world’s GDP. However, this is likely to be transformed in the near future. Various estimates are predicting that by 2030, the middle class will reach 5.6 billion people, which translates into 2 billion people with increased purchasing power, 87% of whom are Asian. India and China combined will represent 66% of the global middle class in just over a decade.1

Most of the emerging countries see the developed markets as an aspiration and understandably want to be part of the growing middle class. We, and other emerging markets investors, consider this a great opportunity. We love talking about the low penetration of various consumer products and long-term secular growth prospects as these markets grow in wealth and size. While the narrative of investing in the emerging markets sounds promising, there is a simple question that investors often forget to ask — what is the negative impact of these positive improvements? We know from the evolution of the developed world that our benefit has come at a cost to the environment. As it stands, we remain the largest environmental offenders from a per capita perspective. Reflecting on the per capita element, the fact that by far the majority of the world’s population resides in the emerging markets and wants a higher

standard of living will inevitably worsen the environmental crisis we face.

Emerging markets equity insights

LGM Responsible Global Emerging Markets team

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Contact us1-844-266-3863

May 2019

Key risks

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Investing in emerging markets is generally considered to involve more risk than developed markets.

1 https://ec.europa.eu/knowledge4policy/foresight/topic/growing-consumerism_en‘middle class’ defined as earning $11 to $110 per day, can expect to live a decent life and have escaped extreme poverty. They are also known as the ‘consumer class,’ the group whose demand powers most economies.

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Emerging markets will require more energy output as they become more power-hungry, leading to more power plants fueled largely by coal given its abundance and low cost of extraction. The inevitable result is larger carbon emissions and air pollution. These consumers will also require more factories, producing short-lived consumer products that will lead to plastic and other types of waste that are likely to end up polluting land and oceans or in our food systems through micro plastics. This is just the tip of the iceberg for the environmental damage that is taking place as billions move closer to becoming middle-income citizens.

For us it is clear that the developed world cannot expect the emerging world to curb their middle-class aspirations in exchange for cleaner water and air. A new approach is required, one where economic progress is not solely calculated based on traditional revenue or EBITDA metrics but also on whether companies are operating in a sustainable2 way to actively minimize their negative impacts, while providing products and services that are improving the quality of life for the masses. Specifically, for the Responsible Global Emerging Markets strategy, we look for companies that have a positive impact by either solving, or being positioned to benefit from, the sustainability challenges in the emerging markets.

In our investment universe, we regularly observe some emerging nations that go two steps forward and one step back in terms of economic development, while others have progressed more steadily — among the latter group is China. China as a nation has done a tremendous job of lifting its large population into the middle class from poverty. China today leads the world in the number of internet users and college graduates and is working to land a person on the moon. It is fair to say China is no longer the sleeping giant portrayed by Napoleon Bonaparte. This success has a cost, though. The ecological environment of this 1.4 billion strong nation, who today eat three times as much meat as in 1990 and consume five times more dairy than in 1995, is faced with declining farmland, where 20% of what remains is polluted and there is visible air pollution in cities.3 Many other challenges are highlighted regularly in the media.

While it is easy to be pessimistic about the future of China with all the negative news that is regularly flagged to us, we remain optimistic that over time they will overcome these challenges. There is a lot of progress that often doesn’t make front-page news. For example, China spends three times more on renewable energy than the U.S. It is also by far the largest investor in this field globally, with renewables expected to reach 35% of China’s energy mix by 2030, up from 12% just 4 years ago.4 82% of Chinese consumers are willing to spend more on healthy food and beverage products, much higher than the global average of 68%.5 To keep the ‘social contract’ between the leadership and the people intact, there is a requirement to change and improve. We are already seeing this and are likely to see more. In other emerging markets, we are seeing countries heavily investing in renewables, banning plastic bags, implementing a tax on sugar — basically taking the social cost from the public and forcing it into the accounts of the corporates. We welcome this and, equally, we demand our companies to prepare for and, where possible, benefit from these challenges.

China spends three times more on renewable energy than the U.S.

2 Avoidance of the depletion of natural resources in order to maintain an ecological balance.3 Coal is still around 2/3 of the energy source for China.4 Source: U.S. Energy Information Administration and https://asia.nikkei.com/Spotlight/Cover-Story/China-s-renewable-energy-surges-after-state-backing5 https://www.nielsen.com/cn/en/insights/news/2018/nielsen-report-ten-trends-of-chinas-consumer-market-in-2018.html

Investment case studyVitasoy (healthy food and beverage producer) demonstrates a number of the qualities we look for in a business. It effectively works towards addressing upcoming sustainable development challenges: it has invested to mitigate the environmental impacts of its packaging and in product R&D to benefit from the structural shift towards healthier products with less sugar and fat.

The health element was part of the foundation of Vitasoy’s creation. Its history begins in Hong Kong in the 1940s, when it was established by KS Lo. He started his business with the intention of fighting malnutrition of the refugees fleeing the civil war in China, after noticing that many immigrants, who came to Hong Kong from mainland China, were also lactose intolerant. After learning about the benefits and efficiency of soybeans, he started Vitasoy to provide cheap protein and nutrition to the masses. Today, Vitasoy is one of the leading plant milk manufacturers in Asia. We like the following aspects of the investment case:

• Vitasoy has a net cash balance sheet, high return on invested capital and has revenue and profits growth of more than 20% year on year, mainly driven by its operations in China, which today makes up 57% of sales. We see Vitasoy as having a long runway of growth ahead, backed by an increase in health awareness and the increasing appeal of plant-based beverages that are nutritious and reasonably priced.

• There is also a good balance between family oversight and a proven management team — the Lo family is still active at the board level and the management is professionally run. The CEO is an Italian executive who formerly worked for P&G and Coca-Cola China.

• Vitasoy has set 2026 targets to improve its sales of plant beverage offerings to 90% (currently 89.5%), increase low-fat products to 93% (currently 92%), increase beverage offerings with moderate to zero sugar levels to 82% (currently 68%) and ensure more than 90% of their packaging is responsibly sourced (already exceeds the initial goal and currently at 91%).

• We like the fact that soy is a very efficient source of protein that contains essential amino acids and is high in nutrients such vitamin B, calcium and other minerals, while also having no cholesterol. At the same time, various pieces of research suggest soy is eight times more efficient in usable protein per acre of farmland relative to meat.6

Thinking holistically about the business implies decision-making that is based on the long-term well-being of all stakeholders and not only shareholders. Our belief remains that consumers in Asia, particularly in China, will continue to demand healthier and more environmentally sustainable products. This growing demand will provide additional tailwinds for Vitasoy, which is why we plan to remain shareholders in this business for many years.

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China, soybean field

Our belief remains that consumers in Asia, particularly in China, will continue to demand healthier and more environmentally sustainable products.

6 https://www.researchgate.net/publication/321491908_A_model_for_’sustainable’_US_beef_production

Vitasoy is a great example of a company that goes beyond just causing the least amount of harm to society and the environment; it is much more about the responsibility it takes, demonstrated by producing products that benefit the customer and at the same time provide an environmentally friendly alternative. We believe ‘living and breathing’ being responsible to society and accountable to stakeholders is the key element for the long-term financial success of any company.

While we think Vitasoy is running ahead of its competitors as discussed above, we believe in being active owners and partners with the businesses that we invest in, and therefore see engagement for continuous improvement as part of our responsibility as shareholders.

Engagement update Vitasoy: We spoke to the CFO and the head of sustainability to gain a better understanding of the company’s approach to tackling key sustainability risks. We expressed our support for management’s commitment to incorporate material environmental and social considerations into the business strategy, as well as the significant progress made over the last few years in improving resource efficiency and the nutritional profile of some of Vitasoy’s brands. At the same time, we noted gaps in the management of environmental, social and governance (ESG) risks in raw material sourcing and encouraged the implementation of stronger practices to identify and manage such risks, particularly those related to climate change in the soybean supply chain. Overall, we believe the company is well positioned to manage the risks and capture the opportunities linked to long-term sustainability issues.

Magnit: We met with the incoming president of the company, Mr. Jan Dunning. Mr. Dunning recently assumed this new role, which was created to oversee management, build a new organizational culture and lead communication with investors. Based on his previous experience as the leader of a major Russian retailer and our conversation with him, we are cautiously optimistic that he can succeed in his objectives. We adamantly stressed the importance of empowering the board and building a strong relationship with its members. Going forward, we will closely monitor any changes in the composition of the board at the 2019 AGM and seek opportunities to engage with directors to assess the board’s appetite and ability to achieve alignment of interests amongst all shareholders when it comes to capital allocation decisions.

Bank Mandiri and Bank Rakyat: We wrote to both Indonesian banks to start a dialogue on their approaches to managing the credit and reputational risks embedded in their portfolios of loans to companies in the palm oil industry. While the industry has come a long way in addressing the environmental and social impacts of palm oil cultivation, there continue to be areas for significant improvement. The letters were co-signed by six other international investors.

Country visit highlights During the first quarter of 2019, the team kicked the tires in Chile, Peru, Colombia, and Mexico.

Chile is a country that punches above its weight as a nation. After lagging behind its Latin American peers in terms of GDP per capita in the 1980s, today Chile is the wealthiest nation on the continent and the leader in the region from a human capital

perspective.7 The political landscape has remained stable, with most recent governments being led by left or right-leaning centrist parties, providing a stable economic environment that has led to Chilean businesses doing well locally and using their excess cash flows to invest, whether regionally or internationally. From this aspect, we cannot emphasize enough the competitive advantage of having stability backed by supportive liberal policies; these advantages are often overlooked in a large number of emerging markets countries. While a great story, Chile also has its challenges: high youth unemployment, limited diversification of the economy away from commodities (copper in particular), high economic inequality levels, increasing wild fires (raging while we were there), melting glaciers and water scarcity. We currently do not have any investments in Chile, but after our meetings we were encouraged by and are following up on two potential investments.

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During the first quarter of 2019, the team kicked the tires in Chile, Peru, Colombia, and Mexico.

7 http://blog.investchile.gob.cl/world-bank-chile-has-the-best-human-capital-in-latin-america – The World Bank defines human capital as the sum of the knowledge, skills and health that people accumulate over the course of their lives.

Torre Latinoamericana in Central Mexico City

Peru’s development has been volatile. Despite returning to democracy in the 1980s, the economic and political landscape has been fighting various degrees of authoritarian leaders, economic crises, hyperinflation, and corruption scandals,

causing restrained investment flow locally and from international investors. The situation is such that the past five presidents are either under investigation for corruption or served time because of it. Even with all of these struggles, Peru has managed to reduce its poverty rate down from 55% in 2001 to 21.7% in 2017, lifting millions out of poverty. The improvement has been curtailed of late as the country has faced political turmoil with the resignation of the former president over conflict of interest allegations. Peru, like Chile, is also very exposed to the mining cycle from which they have benefitted due to the construction boom in greater China region over the past decade: 72% of its exports are commodities, with copper making up 30%, the rest being gold, zinc, oil and gas, agriculture and fishery products.

In Peru, we met with one of our holding companies, Credicorp, which is partly owned by the Romero family, whom we respect as partners. Unlike our other bank holdings that preside over existing strong operations and financial ratios, Credicorp stands out because it has been able to improve itself over time to become a leading bank in Peru. We have seen return on assets (ROA) and return on equity (ROE) increase from 1.4% and 13% in 2013 to 2.3% and 18% respectively, with the efficiency ratio improving from 47% to 43%.8 Another positive aspect of this bank is its subsidiary in microfinance called Mibanco, which offers banking products tailored to micro entrepreneurs, and promotes financial inclusion in underdeveloped segments with the sales representatives also acting as advisors. We are happy with the direction of the travel and the impact element of this holding.

We went to Mexico on a research trip to visit a number of companies and get a better understanding of the evolution of ESG management practices. We found that companies have started to respond strongly to growing public awareness around

environmental and social issues — water availability, air pollution, plastics and inequality in particular. While the policy context to address these issues remains relatively weak, all of the companies we met expressed their belief that the long-term success of their business depends on addressing material environmental and social risks and opportunities head on. Governance is also an area companies continue to focus on, and the notion that good governance practices are critical to success is widely held. However, as is the case in a lot of markets, governance is largely seen as a compliance exercise — i.e., follow the letter of the law rather than its spirit.

During the trip, we met with our holdings Wal-mart de Mexico (Walmex) and Bolsa Mexicana de Valores, the Mexican stock exchange.

Walmex: We met with senior executives, including the CEO, as well as sustainability officers. We came back with the conclusion that the management understands that transformation is vital to the long-term health of the business given changing technology, emerging risks, Millennials and Generation Z, and new competitors. Initiatives to improve digitalization, data analysis, store floor productivity, employee engagement and omni-channel sales have started or will soon start.

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We went to Mexico on a research trip to visit a number of companies and get a better understanding of the evolution of ESG management practices. We found that companies have started to respond strongly to growing public awareness around environmental and social issues — water availability, air pollution, plastics and inequality in particular.

8 Def: the efficiency ratio is calculated by dividing the bank’s noninterest expenses by revenues; a lower ratio signals better operating efficiency.

We had the chance to discuss employee relations at the company. The actions taken by management to enhance working conditions and employee relations over the past few years seem to have been effective in improving the working environment and ultimately employee satisfaction. However, recent events, including a strike threat over wages called by one of the main unions and the looming and potentially radical labor reform promised by the new president of Mexico, indicate that labor-related risks to the business are very much latent. We recognize this latency yet deem such risks to be manageable as well as effectively managed. The company’s continuously evolving approach to engaging with staff and providing attractive and fair working conditions is laudable and should contribute to better retention rates and, importantly, enhanced productivity. We will be keeping a close eye.

Bolsa Mexicana: We met the company and discussed its approach to driving stronger ESG practices among listed companies, while encouraging it to improve its own ESG-related transparency and disclosure. On the former, we welcomed the active role that the exchange has taken, including: membership on the Committee of Corporate Best Practices, the multi-stakeholder body responsible for the publication of the Mexican Code of Corporate Best Practices; sponsoring a sustainability working group of 30 listed companies; and joining the Sustainable Stock Exchanges initiative. As for the latter, we strongly encouraged the company to disclose with enough information on the resolutions being submitted for shareholder approval at AGMs or EGMs.

Portfolio actions and considerations

We have met with Jeronimo Martins on multiple occasions over the past six months on the ground in Portugal, Poland, and Colombia. Jeronimo Martins is known for being a high-quality retailer, providing its customers with value and quality while living and breathing responsibility to all stakeholders. The history of the retailer goes back 225 years, and it is currently run and owned by the Dos Santos family from Portugal. Despite being listed in Portugal, the company makes the majority of its revenue and earnings in Poland and has been expanding into Colombia. Jeronimo Martins focuses on value, quality and efficiency, with a culture of keeping costs low, long-termism and relentless customer focus. We believe they will continue to gain market share in all of their markets as discretionary spending increases. We also believe Colombia can be an important leg of growth given how Jeronimo has managed to build the largest retail business in Poland from scratch.

Jeronimo Martins has an uncompromising focus on what the customer wants and has historically taken decisions that might look questionable in the short term but have been key for the long-term sustainability. Their efforts to decrease the negative impact and increase the positive impact they can have on the communities they operate in is evident through constantly improving private brand product reformulations, with the intent to bring down saturated fat, sugar and salt. The company is positioned to benefit from a growing demand for healthier food, traceability, and consideration for the environment.

We initiated a position in the South African insurance company Discovery. Discovery is a life and health insurer that has expanded into seven markets today. The purpose of Discovery is based on the simple yet complex notion of making people healthier. It was founded by Adrian Gore in 1992 at the end of apartheid and beginning of democracy in South Africa, a country where the doctor density was low and disease rates were high, so innovation and differentiation was essential. The key aspect of this business is the Vitality platform that rewards members for eating better and exercising regularly, which results in fewer claims and prevention of lifestyle diseases. It is a prime example of a company being a great investment while being responsible to its stakeholders. Based on the scientifically proven principles of behavioral economics, the Vitality model is applicable across borders through the idea of shared values and preventive care so is positioned to have a positive impact on many lives.

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The purpose of Discovery is based on the simple yet complex notion of making people healthier.

Adrian Gore is still very much active in the organization, and innovation sits at the heart of his vision. An ‘innovation score’ is a key part of management’s performance evaluation, and there is an annual competition to identify creative new ideas. Today, Vitality helps members save money by remaining active and eating healthily, while serving as a powerful actuarial tool that connects to the price of insurance. Discovery thus has a differentiated product that not only promotes social good but is in itself a profitable business model. We are excited to see this model growing and expect this to continue over the long term.

We also increased our position in Unilever and held a management meeting with them during the quarter. As this is a significant holding in the portfolio, we thought it might be worthwhile to revisit the investment case for the benefit of our readers. Unilever is a leading global provider of FMCG (fast-moving consumer goods) with a portfolio of 400 brands. The company has 58% of sales and 70% of group volumes coming from emerging markets, with Brazil, China, Argentina and India accounting for just under half of their emerging markets sales. The company is extremely profitable, with a 40% ROIC (return on invested capital), if you strip out goodwill. The investment case for this company lies around the strong footprint they have in emerging markets, which enables them to benefit from several of the long-term structural drivers that we see there, such as population growth and increasing GDP per capita. Unilever is also a world leader in the area of sustainability through its sustainable living plan, where the company is looking to make a positive contribution to society as well as reduce its environmental impact by 50% by 2030. We would recommend readers go through the key goals of their sustainable living plan, which can be found on the company website. Unilever is also a business that is going through a transformation and the company is changing its organizational structure to improve innovation via its ‘Connected 4 Growth’ strategy. Over the past two years, the company has restructured the way it deals with product management, creating specialist country management teams, and launching 30 new brands globally. We feel that capital management has also moved to center stage for the company and view very positively the plans that the company announced to accelerate shareholder value creation in their April 2017 strategic review. In our view, Unilever is firmly on the path of creating long-term sustainable shareholder value.

We also increased our position in AK Medical, a leading player in the healthcare space in China. AK Medical is the largest provider in the orthopedic market in China by volume, with a 15% market share. The company is a beneficiary of the aging population in China and has also been a leader in terms of research and development. For example, its 3D printing products have enabled it to penetrate the higher-end segment. We purchased this position in 2018 and used some weakness in the share price to top up our position.

In terms of funding the above, we took some profits in our Indonesian banks after some strong share price increases. We trimmed both Bank Mandiri, one of the most profitable banks in Indonesia, which has a strong focus on sustainability, and Bank Rakyat, the largest provider of microfinance loans in the country. Lastly, we continued to take profits in BIM, our Turkish food retailer.

Sector exposure

We are often asked whether we have any investments in the field of renewable energy. In short, we would love to, but we have not found it easy to identify many investment opportunities yet because of the subsidies provided to these businesses. This could of course change, especially in China after 2020, when subsidies are expected to be phased out; we will follow this very closely to see which businesses continue to prosper without governmental support.

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We are often asked whether we have any investments in the field of renewable energy. In short, we would love to, but we have not found it easy to identify many investment opportunities yet because of the subsidies provided to these businesses.

Other considerations

Over the past 12 to 18 months, we have been gradually increasing the numbers and the weight of our investments in China. This is, in part, thanks to trade disputes between the U.S. and China, which has allowed us to buy some great companies from our watch lists at reasonable valuations, further fueled by the visible improvement in governance, transparency and social awareness of these companies over the years.

Final note

The new year started off with a bang. We have seen the markets rally strongly over the past three months and, as it stands, the strategy is lagging slightly behind. Our goal is to grow capital steadily over the long term in hard currency while striving for capital preservation. Therefore, we expect to perform well in gradually rising markets, or during periods of a market correction. But when low-quality rallies or new fads emerge, our holdings tend to be the tortoise in the race. We believe, however, our investments are best placed to come out as winners in the long term.

BMO Global Asset Management

All investments involve risk, including the possible loss of principal. Past performance does not guarantee future performance.

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Emerging markets equity insights May 2019 • PAGE 8

Our goal is to grow capital steadily over the long term in hard currency while striving for capital preservation.