ESG case study Hermes Emerging Markets Mengniu : Crisis and recovery Gary Greenberg, CFA Head of Hermes Emerging Markets and Lead Portfolio Manager

With new management and a Results government focus on improving food The company was making all the right moves: it was only a matter of time before this was recognised by the stock market. Dairy giant safety, the company has recovered from later acquired a 4% stake in China Mengniu Dairy and the two companies subsequently entered into a joint venture, in which the a poisoning scandal to fast become local company gained an 80% stake, to produce and distribute yoghurt a world-class consumer goods provider. in China. Since then, the companies have collaborated in R&D and on measures to improve the supply chains of China Mengniu Dairy’s baby formula and pasteurised milk businesses. Concern In 2008, several Chinese infants died and 296,000 children fell ill after drinking melamine-poisoned milk produced by domestic dairy companies. Shares in China Mengniu Dairy, one of China’s major milk producers, more than halved in value and were suspended from trading amid the crisis. The company’s management team later exited and a former Coca Cola CEO took charge, appointing staff with international experience in dairy production and distribution. So began the company’s recovery.

Action Identifying this change and other positive stock fundamentals, we Driven by a better supply chain, a stringent focus on food safety and invested in the company in early 2012. Hermes EOS, our stewardship quality control, the promotion of its key brands, partnerships with team, subsequently engaged the dairy producer and confirmed that Danone and Danish dairy company Arla, plus its entry into the baby- it was improving its practices: a new quality-control division reported food market, the company typifies the disciplined, efficient, growing directly to the CEO, detailed guidance was provided to suppliers, the and sustainable companies that we seek in emerging markets. The sourcing of produce was being streamlined in order to reduce the stock appeared expensive at first, because China Mengniu Dairy was number of intermediaries in a market with an extremely fragmented investing for future growth rather than focusing on short-term gains, supply chain, and more third-party checks on product quality were being but has risen 45.76% from early 2012 to August 2017. made. These internal improvements occurred amid supportive external factors: improving regulations to address the public’s concerns about food safety in China, and rising milk consumption from a low base. Stock performance of China Mengniu Dairy 25 In 2013, I visited one of China Mengniu Dairy’s milk-processing plants. I saw spotless new German and Swedish equipment automatically 20 producing dairy goods that were tested twice for 100% purity before Initial purchase being packaged in containers that were digitally tagged. The machinery, 15 sealed off from walkways by glass enclosures, was flushed clean every 24 hours. Employees’ mood, gauged through a translator, seemed to 10 be very good. Share price (HKD) 5 Jan 11 Jan 17 Jan 12 Jan 15 Jan 13 Jan 16 Jan 14

Source: Bloomberg as of 18 August 2017. This stock was bought in March 2012 and is still held within the portfolio.

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