Analysing ESG factors for risk and opportunity
Portfolio Managers Brian Demain and Cody Wheaton explain that environmental, social and governance (ESG) factors have become a significant risk/opportunity consideration for both companies and investors.
- In an increasingly transparent world, ESG factors have become a significant risk/opportunity consideration for companies and, therefore, investors must account for them in their research process.
- As ESG awareness increases, management teams dedicated to long-term growth are focusing not only on shareholder returns but also on positive outcomes for customers, employees, suppliers and the environment.
- We believe no company can thrive over the long term at the expense of these key stakeholders; therefore, it is essential to understand any practices that are not supportive of these areas and that may impede a company’s long-term growth potential.
A heated debate continues around environmental, social and governance (ESG) analysis as investors evaluate the potential impact on investment outcomes. There are many lenses through which to view this topic, and years of thoughtful consideration and investment experience have ingrained in us a simple approach: While ESG has become increasingly mainstream, we think these factors have always been an important risk/opportunity consideration for companies and, therefore, investors must account for them in their research process.
A more transparent world, more responsible companies
We operate in a world with a level of transparency, media amplification and speed of information flow greater than we have ever seen. Outside of investing, we can think about the story of Mohamed Bouazizi to illustrate this dynamic. In 2010, faced with a ruling order indifferent to the working class’ desire for justice and dignity, the Tunisian street vendor lit himself on fire, thus triggering the Arab Spring uprisings. In another time, the incident would have likely remained an isolated event. But in 2010, his actions started a dozen revolutions. One man’s act, amplified by social media, caused a sea change in perception across the entire Arab world. Poor treatment of the working class ‒ an endemic problem ‒ was suddenly the only problem.
If someone was looking at the risks to stability in those countries, citizen living conditions would be a significant risk factor. This may not have mattered for years, until one day it did. Then, it would be all that mattered.
The takeaway is that, in today’s increasingly transparent world, risks can intensify much faster than ever before. And in this environment of enhanced visibility, companies are increasingly being held to a higher standard. Poor treatment of various constituencies can very quickly escalate into issues that damage a company’s reputation. Alternatively, acts that delight various stakeholders can create virtuous impacts on a company’s standing. As such, ESG analysis becomes an important part of assessing risks and opportunities. Though corporations may not necessarily adopt responsible ESG practices out of selfless motivation, they may do so because that is what society demands of them in a world of transparency.
Conventional wisdom for decades held that the principal focus of management should be to maximize profits to shareholders, sometimes at the expense of other stakeholders. Our opinion is that a holistic view may be more favorable to company value. Management teams dedicated to long-term growth that adopt a stakeholder approach to governance, focusing not only on shareholders returns but also on positive outcomes for customers, employees, suppliers and the environment, may be better positioned in the long run. It is our belief that no company can thrive over the long term at the expense of these key stakeholders; therefore, it is essential to understand any company practices that are not supportive of these areas and may cause harm to long-term growth potential.
Integrating ESG into an overall analysis
There are numerous examples of positive ESG factors that dovetail with broad investment themes and individual company growth prospects. Regarding environmental issues, we see the automotive industry progressing away from traditional internal combustion engines toward more environmentally friendly electric vehicles and an ever-increasing amount of digital technology per vehicle. This may benefit companies in automotive end-markets that supply into the electric vehicle and automotive technology themes.
From a social standpoint, we see areas of opportunity in companies that are using technology to remove historically undesirable practices. For example, companies are using real-time payments of employee compensation to disintermediate payday lending, an industry that burdens lower wage workers with usurious interest rate loans. These companies bring value to those employees, building goodwill that allows them to offer additional products and services. We have also identified companies with exemplary corporate governance; this includes a strong board of directors, track records as excellent stewards of capital, and management teams with a history of operational excellence and the ability to build strong corporate culture. This type of governance framework increases confidence in a firm’s ability to execute on strategic projects such as the merging of a high-performing standalone company with an under-performing division.
Overall, we believe in the importance of taking a long-term view and employing a fundamental approach to security analysis that seeks to identify companies that are differentiated by their sustainable competitive advantages and durable growth potential. To be clear, it is our opinion that numerous factors go into the decision to hold a security – one of which is an evaluation of the unique ESG factors that may help support, or detract from, a company’s long-term cash flow growth and security valuation. Going forward, as ESG factors will likely continue to be key to the long-term health of companies, we think these considerations should be an integral part of assessing the risk and opportunity in an investment.
C-0221-36685 03-15-22 TL