GETTING TO GRIPS WITH ESG
ESG is now an investment buzzword. The term was seemingly coined as recently as 2004 in a report
produced under the United Nation’s Global Compact initiative, titled Who Cares Wins: Connecting
Financial Markets to a Changing World. The report argues that financial metrics do not tell the
full story about a company; due account also needs to be taken of its environmental (E) footprint,
the social impact (S) of its business and the quality of its governance structure (G). Now, ESG has
not won over all investors; some regard it as a fad and argue that their fiduciary responsibility is to
“maximise return”. Proponents of this view point inter alia to the fact that over the long term the socalled “sin stocks” of tobacco, alcohol and gambling companies have delivered the best returns.
Sir John Templeton famously stated that the four most dangerous words in investment are: “This time it’s different”. Contrary to this wisdom, we take the view that when it comes to ESG, this time is indeed different. The basis for our belief is the democratisation of information. As per John Bornstein: “The communications revolution has given millions of people both a wider and more detailed understanding of the world. Because of technology, ordinary citizens enjoy access to information
that formerly was available only to elites and nationstates. One consequence of this change is that citizens have become acutely conscious of environmental destruction, entrenched poverty, health catastrophes, human rights abuses, failing education systems, and escalating violence. Another consequence is that people possess powerful communication tools to coordinate efforts to attack those problems.” However, our experience is that most Trustee Boards have struggled to get to grips with ESG factors. To us, the barriers appear to be an understanding of the ESG jargon and the difficulty of developing a policy with measurable outcomes, issues that we cover in this article.
NEGATIVE OR EXCLUSIONARY SCREENING
This policy is about the exclusion of entire sectors, companies or countries from investment based on ESG criteria, moral or ethical views, or religious beliefs. The firms generally targeted by negative screening include weapons, tobacco, alcohol and gambling companies.
Currently, the dominant screening issue is whether investors should avoid fossil fuel holdings. The argument is, of course, that the product of these companies is responsible for climate change and global warming. The Board may consider, after proper analysis, that fossil fuels are a major factor contributing to global warming. Even so, the final decision requires consideration of wider factors. These companies are major employers and taxpayers and simply banning these holdings
from investment portfolios would almost certainly have unintended effects. In addition, excluding these companies would make the already limited South African opportunity set even smaller. The alternative approach is to engage actively with these companies around what they are doing to reduce carbon emissions. This approach falls under the heading of “active ownership”.
Naturally, this approach is to seek out companies that are demonstrating positive ESG performance relative to their peers. The underlying belief is that that companies that have superior ESG characteristics will out-perform over the long term. The evidence on this is mixed. The basis for higher future returns from companies with positive ESG traits is that the market consensus price
does not give full recognition to the value of these characteristics. In addition, “ESG positive” companies may benefit from a momentum effect as a growing demand for a set of stocks can push up their prices, even in the absence of new fundamental information. However, in the longer run, if ESG-focused investing reaches a high permanent level of penetration among investors, it is difficult to see how any outperformance could be sustained.
Firstly, the under-reaction to intangible ESG information would disappear as many investors pursue strategies based on such information. Secondly, the momentum argument is based on growth in demand, which is temporary by nature. Finally, the larger the group of investors who pursue ESG strategies is, the more neglected and potentially mispriced other stocks become. Thus, arguably, the more popular ESG strategies become among investors, the larger is the likely future under-performance because of the overpricing arising from herding. So, while we can see the case for implementing an “ESG positive” strategy based on being an “early adopter”, we are less convinced that this is a winning strategy for the long term, as it is too easy to implement. Of course, some Boards could follow this approach because they believe investing in ESG positive businesses is morally or ethically the right thing to do. In practice, it is very likely that the Board would want to delegate the choice of such investments to their fund managers, in terms of a suitable investment
This approach involves the inclusion of ESG factors alongside financial analysis in the research process of the investment manager. The aim is to improve the risk adjusted returns, mitigate ESG risks and identify investment opportunities created by a positive ESG change.
Our view is that investors should, when appointing an investment manager, assess the extent to which the manager integrates ESG into their research process and assessment of fair value, although the position is somewhat nuanced. For example, an investment manager may buy a stock with a short-term investment horizon, expecting an earnings surprise or an expansion
in the price/earnings multiple. In such cases ESG factors are less relevant. However, the longer the
expected holding period, the more important ESG factors become. Importantly, in this instance the Board outsources the integration of ESG into the investment process to its appointed investment managers. It is important to consider the skill of the manager in this regard, particularly for managers that adopt a long-term investment horizon.
This approach is based on engaging with companies on ESG concerns that affect their long-term growth and using shareholder power to influence corporate behaviour. This approach is different to the “corporate raider” style of shareholder activism associated with asset-stripping and financial gearing with the aim of pumping up the share price and then “flipping” the share. Instead, the aim is to promote positive change within the company to strengthen its financial performance.
In practice, active ownership is most often directed at improving the governance element of ESG, although it can extend to social benefits and improvement in environmental practices. We consider this to be an under-used and potentially gainful area of investment, particularly since we believe there is scope to improve corporate governance in many South African companies.
While the larger asset managers can exercise influence via the voting rights delegated by their clients, often the impact is limited. This outcome arises firstly because they struggle to get resolutions passed (or defeated, as the case may be), as many other asset managers will vote with management on the basis that selling the share is the recourse if they are unhappy about an ESG
matter, as opposed to effecting change.
Secondly, it is common for the Board of the investee company to make promises that things will change, but to water-down the changes that are finally implemented. The best way to remedy the position is for the manager to have Board representation, so that they can be actively involved in making the required changes. However, investment managers are very reluctant to take up Board positions as this makes them insiders and limits their ability to trade out of the stock.
Finally, we believe that there is undue emphasis on the voting component of active ownership. Often more productive results can be achieved via effective engagement with management on an issue instead of putting it to the vote.
Impact investing is investment in companies and funds with the express purpose of solving social or
environmental problems. It differs from ESG investing (which focuses on the analyses of sustainability factors to understand their impact on future investment returns) in that it prioritises positive social and environmental outcomes as a specific objective, alongside investment returns.
At the heart of impact investing lies the decision between the relative weighting given to positive social and environmental outcomes versus investment return. Clearly, there are institutions and investors that are prepared to forego investment returns (or earn a lower risk-adjusted return) for social and environmental good. However, we are of the view that retirement fund Boards should seek at least fair risk-adjusted returns on any capital they allocate towards impact investing.
Not only do such Boards have a fiduciary duty, it is also a social objective to deliver decent retirement benefits to the fund membership. There are instances where impact investing has, in fact, delivered strong risk-adjusted returns. This outcome is possible because well-run impact investment projects can eliminate the inefficiencies of some government-managed projects
and the potential profiteering of rent seekers.
The case for impact investing stands on the observation that investors must live in the society shaped by their investments, and therefore socially and environmentally positive investing is inherently in their interest. In the long term, businesses can only thrive if the wider
economy and society does well, so investors should prioritise investments that enable a more resilient economy, society and environment.
THE CASE FOR IMPACTING INVESTING IN SOUTH AFRICA
South Africa is a country plagued by a high unemployment rate and a low economic growth rate,
which is largely attributable to a creaking infrastructure and the lack of a meaningful competitive advantage (e.g. natural resources that can be extracted at low cost, a skilled or low-cost highly productive workforce). At some stage the poorest of the poor will lose hope of a better future, and at such a time they might easily be persuaded by populist politicians that a state-controlled
economy which includes nationalisation of key sectors is the right solution for the country. Expressed differently, our view is that the probability of some form of state failure increases significantly unless meaningful progress is made to uplift the lives of the poorest in our society over the next 10 to 20 years.
Some would argue that such upliftment is the responsibility of the government of the day, to be funded from taxes, notwithstanding that many who share this view are cynical of the government’s ability to spend wisely. The reality is that the South African government probably does not have access to the financial resources to fund such initiatives, with the debt-to-GDP ratio being
perilously close to the level at which the rating agencies will consider further ratings downgrades. That is why prescribed assets are being touted as a possible policy initiative.
The need for prescribed assets would reduce if retirement funds, of their own volition, decided
to allocate capital to projects that have impact characteristics. However, the reality is that the
opportunity set is limited at this time, although there is the occasional chance for retirement funds to invest in socially beneficial projects, such as affordable infrastructure, housing, low cost healthcare, agriculture, education and affordable funding for small and medium sized enterprises. The first step would be for retirement funds to indicate an interest in such opportunities, rather
than, as has been our experience in several instances, a stance which precludes such investment based on complexity and the lack of liquidity.