How ESG investing can deliver on both performance and principles

26 May 2021

7 minute read

Investors are increasingly using environmental, social and governance (ESG) ratings to screen investments, so portfolios can proactively protect people and the planet. The COVID-19 pandemic has accelerated this trend in ethical investing. While the world has been turned upside down by the virus, so too has the outlook of many investors. People are now more aware of long-term sustainability risks. But ESG ratings are not just being used to analyse ethics, they can also work out if a company is worth investing in.

ESG data gives a good indication of the operational quality of a business, and how well it’s positioned to negotiate the risks and opportunities of future cash generation that ESG considerations present. Our sustainable investment strategies combine this bottom-up quantitative and qualitative ESG analysis into the investment due diligence process. Each pillar within ESG allows investors to better understand a company, with the aim of generating better returns.

The ‘E’ in ESG: why environmental protection matters

International efforts to reduce greenhouse gas emissions are set to intensify this decade as nations significantly step up their climate commitments.To meet the Paris Agreement objectives of 2015, by limiting global warming to below 2°C, accelerated action is likely later this year when nations meet at COP26 to set new five-year targets to tackle the climate crisis.This will bring increasing environmental regulation, higher carbon costs, greater transparency and greater customer scrutiny.

Companies who aren’t carbon efficient may face large risks to future cash flow – and future dividends. Higher carbon pricing will increase both the cost of operations and goods – directly impacting profitability if companies can’t pass those costs on.

Last year, Unilever – one of the world’s largest consumer goods groups – announced that it was putting carbon footprint labels on all its products1. As other businesses follow suit, it’s likely people will become far more conscious of the carbon emissions from the products they buy.

It’s therefore prudent to consider these factors when working out the future revenue of a business.To do this, metrics such as ‘gross cash flow per tonne of CO₂ or equivalent greenhouse gases’ or, ‘scope one and two emissions per US$1m of fixed tangible assets’ can give insights into the resource efficiency of a company.

A company such as Apple is in a better position to drive change than one of its smaller suppliers.

Carefully assessing a company’s dependence on factories and the remaining expected life of those assets, can help us to understand how willing an organisation might be to upgrade their ESG credentials. ‘Fixed-charge coverage ratios’, ‘margin volatility’ and a company’s available funds can also help us make sense of whether they can afford to transition.

Working out the influence and power of a company in its supply chain is also useful. For instance, a company such as Apple is in a better position to drive change than one of its smaller suppliers. Common accounting metrics such as ‘gross margin’ and ‘accounts payable days’ – the length of time it takes to clear all outstanding supplier and vendor payments – can help us to gather this information.

Analysing a company’s capitalised research and development to its gross investments as well as price-to-book ratios – a company's market value relative to its book value – can help determine where value is building in a supply chain. Knowing where a company is seeking to add brand value and adopting a policy of differentiation to stand out from its competitors is also useful. The more protective a brand is of its reputation, the more likely it is to drive constructive change in its supply chains.

The ‘S’ in ESG: how a solid social strategy makes more than financial sense

Since 1975, the share of intangible assets to the total market value of the S&P 500 has risen from 17% to an astonishing 90% today2. Intangible assets, which aren’t physical in nature, include brand recognition, intellectual property, acquired goodwill, royalties and licensing, data and relationships.

For instance, in the technology space, one of Google’s most valuable intangible assets is its search algorithm, and for Facebook it’s the stores of data it has on its customers. While in pharmaceuticals, Reckitt Benckiser’s Nurofen brand and the patents on Johnson & Johnson’s immuno-oncology therapies are also both highly valuable assets. These intangible assets are products of human intelligence and creativity. Therefore, a workplace that can attract and retain great minds is of great value.

Our sustainable strategies look to only invest in the highest quality, knowledge-based businesses from across the globe. It’s therefore paramount we know how companies manage their workforce.

Can a company retain and develop talent? You can build up a picture by viewing metrics such as employee turnover, salaries, employee share ownership and training hours. How does it treat its female employees? Gender pay gap information, maternity and paternity pay can give plenty of insight. Perhaps the most important aspect, yet hardest to quantify, is the strength of a corporate culture, which underpins the small day-to-day decisions driving the larger outcomes of a company.

We only have to look at the current situation of staff safety in the pandemic to understand the impact of such factors. Companies with poor health and safety policies have had to close due to COVID-19 outbreaks – such as the food processing firms frequently mentioned in the press.

Those that have acted quickly and decisively have stayed operational and even thrived. Amazon, while under much media scrutiny early in the pandemic, invested into several initiatives to keep their workforce safe – including its own in-house COVID-19 testing which has reduced the amount of absences. Not only has Amazon remained operational throughout the pandemic, it’s also added over 400,000 staff to its workforce3 and now generates more than US$1bn of revenue a day4.

The ‘G’ in ESG: a focus on governance and the rest will follow

Powerful environmental and social policies can drive operational quality, reduce risks to future cash flow, attract the best talent, and encourage firms to operate sustainably within our planetary confines. However, none of this can happen without effective governance.

You can learn a lot from the compensation structure of a company’s leadership when looking to understand its priorities around ESG. An analysis of leadership structure can also highlight a company’s true motives behind driving ESG quality. For example, if the head of sustainability reports directly into the C-suite, it indicates a more serious commitment than if they’re positioned further down the organisation.

Bottom-up ESG research is a crucial part of the investment due diligence we carry out on all of the companies we look at within our sustainable strategy. This extra information allows us to make better investment decisions. In a world rife with the dangers of climate change and social injustice; where geographical boundaries have fallen away to include a global, remotely-working workforce, a focus on ESG quality has never been more crucial to both companies and investors.

All of the companies referenced in this article were companies held by our Sustainable Total Return Strategy as of 31 December 2020. They may or may not still form part of our portfolios. Reference to specific companies is not an opinion as to their present or future value and should not be considered investment advice or a personal recommendation. They’re included in this article to demonstrate the positive impact companies can have.

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