In seeking to invest in quality companies, engaging management on environmental, social and governance (ESG) issues is entrenched in every step of the decision making process for FSSA Investment Managers.
In seeking to invest in quality companies, engaging management on environmental, social and governance (ESG) issues is entrenched in every step of the decision-making process for FSSA Investment Managers.
The market volatility in early 2020 has shone a spotlight on the importance of ESG in helping to drive investment returns. The resilience of funds that take these issues seriously has encouraged many investors to re-allocate accordingly. Data from Morningstar, for example, showed that global sustainable funds pulled in $45.6bn in the first quarter, while the overall fund universe saw an outflow of $384.7bn during the same period.
While encouraging, this is of no surprise to investors who understand the importance of ESG factors to a company’s financial performance. It simply reflects the inevitable flight to quality in times of market stress: better-quality companies should survive and prosper once we are past Covid-19. Conversely, companies that take ESG shortcuts will be found out eventually.
FSSA’s approach to responsible investing has been shaped by a strong emphasis on stewardship, in conjunction with the belief that quality managers and good governance should ensure environmental and social concerns are addressed.
This philosophy has underpinned the investment process since the establishment of the team. To us, sustainability is not just a label, but a set of values by which we operate. As an example, the firm has been a signatory to the Principles of Responsible Investment (PRI) since 2007.
Focusing on what counts
In an industry where the interpretation of ESG factors varies, FSSA prioritises quality. In short, this relates to the strength of management, financials and franchise when considering an investment in any company.
As long-term investors, we measure success over years, not quarters; therefore, our focus is on management teams that are well-aligned with minority investors and respect all stakeholders, both in good times and bad. Our starting point is, ‘what could go wrong?’ – for example, if interest rates normalise or regulation tightens.
This also means avoiding companies that pursue immediate gains through short-sighted strategy and reckless conduct, or by exploiting labour, tax loopholes, legislative arbitrage or the environment.
The outperformance of FSSA’s funds during market downturns is perhaps the best evidence of the value of integrating ESG in investment decision-making. It also reflects how the team has adapted as additional factors material to the firm’s investee companies become clear.
Our investment process leverages a schedule that includes around 1,600 meetings a year – and we consider each of these meetings as an opportunity to engage with management at various companies. We want to understand what targets a company might not have met, and why, in order to form insights on the quality of the company.
We believe the key is to be pragmatic. Our engagement approach is based on a clear understanding of industry best practice and using this knowledge to probe management on how they operate the business – especially with its customers, employees, suppliers and the wider community in mind.
Based on our experience, these types of conversations can help portfolio managers judge a company’s commitment to ESG based on its response to such enquiries. This might mean that certain holdings are replaced following a review of a company’s ongoing ESG compliance.
Our engagement process has been an important evolution over many years and the team have adopted a more holistic approach to ESG. Our evaluation process highlights where our engagement on issues – such as the quality of corporate governance, or how a company deals with environmental and social matters – can have a material impact on earnings and valuation.
Key ESG themes
- Air quality and polution
- Climate change
- Energy use
- Waste and conservation
- Water management
- Community initiatives
- Diversity & equal opportunity
- Employee engagement
- Health and safety
- Labour and working conditions
- Supply chain risks
- Accountability and audit
- Directors, experience and quality
- Effective communications
- Management functions
- Risk management
A shared goal
Broader industry alignment over the positive impact of ESG and sustainability analysis on long-term investment performance is gaining momentum. Yet, more work needs to be done to dispel certain myths and address lingering misconceptions about fully integrating ESG into the investment process.
Among these is the view that ESG considerations and corporate profitability are mutually exclusive. We disagree; we believe companies that take ESG seriously will also look after shareholders in the long run. At the same time, the focus on ESG doesn’t have to be purely ‘green’; in our experience, a company that is poorly governed will typically not care about society or the environment either.
Beyond data, greater transparency and more consistency in corporate reporting on the challenges faced would help promote the effectiveness of ESG.
One of the indicators of a company’s willingness to do the right thing by all its stakeholders is whether it has incentivised management to do so – and whether there is an ESG committee to report to senior executives.
Ultimately, it is the responsibility of the management to live up to the corporate promise. While some companies claim to have a strong commitment to ESG, we believe evidence of its importance can often be found if it is mentioned in the chairman’s statement in the annual report.
Source: Morningstar, as at 31 March 2020
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