Why we care about ESG
The Saracen team discuss the importance of ESG, the impact on portfolio construction and performance and our approach…
ESG has become the buzz word in investing over the last few years. It seems everyone is talking about it and ever more people are trying to find out about it. Just look at the following chart of “ESG” and “ESG investing” searches on Google:
So, what’s Saracen’s ESG approach? First up, we are not turning into an ESG house nor we are not jumping on a bandwagon. But we would like to highlight the following points in this blog:
- What is the purpose of ESG research?
- How does ESG impact portfolio construction and performance?
- How do we apply this at Saracen?
Why did a company like boohoo, which was rated so highly, unwind? Why do so many technology businesses score so poorly on governance, yet don’t get called out for it? We want to make sure we understand our ESG data and don’t fall in whitewashing traps! In this blog we will highlight some of the vagaries in reporting systems, but also emphasise the importance of due diligence by the Analyst in spotting and interpreting potential issues.
We will use lots of examples across our fund range throughout and also give our reasons for holding shares in the oil & gas and tobacco sectors, which are often shunned by others.
What is the purpose of ESG research?
We see ESG analysis as a natural extension to our fundamental research. It provides another risk overlay that highlights potential problems or solutions within a company that might not be captured in the financial analysis, e.g. the reputational or brand risk for a business not adhering to social responsibility factors, or raising the governance issues such as nepotism. Another aspect would be the negative impact in culture of not having equal opportunities, whistle-blower policy, high staff turnover and so on. Successful companies tend to set high, but fair standards and fully accept both the economic and moral rationale for implementing ESG targets. When managers drag their feet or are unwilling to move forward constructively, they are often hiding other issues which are likely to negatively impact the long-term growth of the business.
We view a low ESG score as a potential warning sign that can lead to us either not purchasing a share or selling a holding where we feel the risks are not appropriately recognised by management.
We don’t invest based on the highest ESG ranked companies, we view it as complimentary to our other research. We hope to record improvement, which we expect will lead to better operating performance and ultimately a higher rating on the shares. We maintain a strict valuation discipline to our investment decisions. ESG provides greater depth to the discussion, to highlight businesses that are embracing environmental, social and regulatory change and flagging the risks surrounding others who prefer a less open and responsible analysis of their actions and behaviour.
Once businesses set targets for omissions, energy usage etc, management are typically incentivised to meet them. If we can identify businesses that have the products or knowledge to help them improve their performance, then both parties stand to benefit from their collaboration.
Let me explain this with a few examples.
We recently purchased Wienerberger: it manufactures bricks, concrete, roofing and pipes. On first glance this is a highly energy intensive company with a high carbon footprint. To be fair, its Environmental rank is relatively low, albeit improving. During the past five years, Wienerberger has worked towards its Sustainability Roadmap 2020 and markedly reduced its energy consumption and CO2 emission while at the same time increasing the use of recycled materials. The company is also making more products that will help its’ customers improve their energy efficiency; 35% of products have been developed in the last five years. There is much more to come. There is no doubt that Wienerberger’s Roadmap is making a positive impact on the environment and the company. These initiatives also had a positive impact on financial returns, such as gross margins, which expanded by almost 400bp over the last five years in part due to reduced energy costs and CO2 permit costs. In our forecasts we see further margin upside potential, which in turn should lead to higher profits, valuation expansion and ultimately to a superior return for our portfolio and clients.
It is a similar case for Heidelberg Cement, who as the name says, produces mostly cement. Again, a highly energy and CO2 intensive business. Many investors ignore the shares due to the perception that the cost to offset CO2 emissions are prohibitive for Heidelberg. However, the company is trying to get back on the front foot – they have set ambitious targets to reduce carbon per tonne and they have identified measures they can implement which don’t require significant capital outlays, e.g. reduce the clinker component in cement which would actually lead to a reduction in cost and an increase margins. If Heidelberg can make this transition successfully, in a cost–effective manner and faster than peers, we would expect investors to re-visit the sector and the shares to re-rate.
Many ESG credentials depend on a company’s manufacturing footprint and impact on society. It is also important to evaluate the impact their products have on their clients: there is growth in helping customers meet their ESG targets. Take Schneider Electric for example, which is highly ranked in its own right being a Corporate Knights Global 100 Most Sustainable Corporation and was recognised for actions to cut emissions and mitigating climate risks. Schneider is a manufacturer and supplier of hardware and software that increases automation and improves energy efficiency. In effect, Schneider’s products are used to reduce their clients’ carbon footprint. Over time, the demand for these energy efficiency products should lead to market share gains and higher returns for shareholders.
We are often asked why we own tobacco shares. Are they not a lost cause in times of ESG? Again, we would like to point out that we support a change in business culture and a path towards a better company and society, not necessarily the status quo. The best example here is our investment in Philip Morris International (PMI). Its valuation – like the rest of the sector – suffers from the negative impacts smoking has on society. What is not yet reflected in valuation or ESG scores are the structural changes PMI has gone through in the last 10 years which culminated in the launch of IQOS 5 years ago. It’s PMI’s “goal to replace cigarettes with the smoke-free products.” This reduces the risk to smokers compared to a traditional cigarette and to passive smokers. Overall, the impact on society would be enormous if every smoker moved to IQOS. Although this won’t happen, the trend is encouraging. The company has invested heavily over the last 10 years and it is miles ahead of competition. IQOS is not classified as a combustible tobacco product, so taxes are lower. This has a positive impact on margins, ROIC and in turn should lead to higher valuation and better returns for our clients. One unquantifiable aspect of the new strategy is the reduced litigation risk for PMI.
Another sector that is shunned by ESG investors is oil & gas. Even here we can detect changes, that will contribute to a better society. We currently own shares in Wood Group in our UK funds, which prior to the purchase of Amec Foster Wheeler in 2018 was predominantly an oil services business. Today upstream oil and gas accounts for only around 35% of revenues and the group now has significant business in alternative energy sources such as wind and solar and are developing promising services in areas such as carbon capture and hydrogen. All of this means that Wood Group should now be at the heart of the energy transition process away from fossil fuels over the long run and a leader in ESG in the oil & gas sector. The shares have been friendless in recent years, but we now see a period of recovery ahead, driven by their increased exposure to faster-growing environmentally friendly services. Wood is now ranked at the top end of its peer group by both MSCI and Sustainanalytics, giving further credibility to their ESG credentials.
We mentioned that we like to support companies on their way to become ESG leaders in their field. Danone is already highly ranked for its plant based dairy business and it is the first listed company to adopt the “Entreprise à Mission” model, which incorporates ESG factors into its Articles of association. But its water business has many red flags when it comes to ESG (sustainability of sourcing, packaging, carbon footprint). At the start of the year Danone announced a €2bn investment programme that will combat all these issues. In the short term, this means a hit to margins. But we believe in the long term it will set Danone apart from the competition and will increase its brand value and reputation – something that will be reflected in valuation over coming years.
ESG analysis has also helped us to avoid some higher risk companies, which would have looked interesting on fundamental analysis alone. Again, let me demonstrate this with a few examples.
We used to own a healthcare company which we discovered, owns a luxury hotel and vineyard. This was often used by management despite the location being in a country far from the Head Office. This raised many questions with regards to Corporate Governance and management focus. While we raised our concerns with management no action was taken and we decided to sell our investment.
Another example is a Chinese staples company we researched in the past. On a PE basis the company appeared attractively valued. However, during our ESG analysis it became apparent that most of the members of the management board were related. Furthermore, the CEO and other members held private businesses which in turn transacted with the staples company. We could not clearly identify if these transactions were made on an ‘arms–length’ basis. As in the previous example, it raised all kinds of red flags and it reduced the Social Governance score dramatically. We refrained from investing in the company as a potential accounting fraud risk was too high. The shares subsequently tumbled and never really recovered, greatly underperforming the Chinese and global staples sector.
How does ESG impact on portfolio construction and performance?
As mentioned above, we use ESG analysis as another risk overlay to our research process. It determines if we invest in a company and to what extent. A low but tolerable ESG score will result in a lower portfolio position, just like any other increased risk metric would lead to a smaller position. For our clients, this means additional downside protection and risk minimisation. It can also highlights businesses, which over the next few years might become ESG leaders in their field, but where the market has not yet given the company any credit for their transformation.
How do we apply this at Saracen?
Since 2011 we included socially responsible investment factors in our company research templates. As the debate about sustainable investing and ESG factors has evolved, so has Saracen’s process.
There are numerous ranking systems and even more definitions on ESG. How does one compare system A to system B? How come a large company like BASF gets 44 out of 100 with RobeccoSAM but 84 out of 100 with Sustainalytics? Similar for Unilever: 100 from RobeccoSAM and 54 from Sustainalytics. (Source: Bloomberg). The issue is that often these rankings are based on tailor made questionnaires, which leave room for objectivity and can’t be easily compared between providers.
At Saracen we require data that we can verify and is as objective as possible. We settled on a detailed score card from Bloomberg, which in turn is based on publicly available information, mostly in annual accounts, sustainability reports and ESG policies.
Every company is ranked on each of the ESG pillars and is given an overall score. This is imbedded in our analysis and discussion on any investment.
The score card is detailed (and this blog is not the place to explain the intricacies), but we are more than happy to talk interested clients through our analysis process and we are always here to answer any questions you should have.
As always, at Saracen we pride ourselves at being open and transparent with our clients and hope our application of ESG should be just as well understood as our investment approach.