How ESG data is helping investors succeed

Emerging as a megatrend, investors are increasingly opting for Environmental, Social and Governance (ESG) conscious investments as they become more aware of the impact their portfolio has on humanity and our planet. While the boom has correlated with the COVID-19 pandemic, this is expected to be just the start of ESG’s growing popularity.

Investors are increasingly recognising the opportunities presented to those companies that perform well from an ESG perspective. ESG data offers a good indication of the operational quality of a business. It’s also a good indicator of how well it’s positioned to navigate the risks and opportunities of future cash generation that ESG considerations present.

This article demonstrates how each element of ESG allows investors to better understand a company, with the aim of generating better returns. Our sustainable investment strategies integrate this bottom-up quantitative and qualitative ESG analysis into the investment due diligence process.

Unless otherwise stated, companies referenced in this report were companies held by our Sustainable Total Return Strategy as of 31 December 2020 and may no longer form part of our portfolios. Reference to specific companies in this report 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 report to demonstrate the positive impact companies can have.

Environmental: protecting the planet

As the world comes together to lower carbon intensity, new regulation will come into play this year. To meet the 2015 Paris Agreement objectives, there will be 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. Higher carbon pricing will increase both the cost of operations and goods – directly impacting profitability if companies can’t pass those costs on. The path to abatement may be expensive for carbon intensive businesses as lowering emissions could put pressure on future free cash flow - and future dividends.

Last year, Unilever announced plans to incorporate carbon footprinting on product labels¹. As more businesses follow suit, what impact will this have on customer purchases? It’s likely people will become far more conscious of the carbon emissions from the products they buy. It’s therefore essential to consider these factors when assessing the future revenue of a business.

To do this, we use a quantitative approach and then do further qualitative analysis. 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 detailed insights into the resource efficiency of a company.

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. Metrics such as ‘fixed-charge coverage ratio’, ‘margin volatility’ and a company’s available funds can help us understand whether they can afford to transition.

Understanding the influence and power of a company in its supply chain is also useful. For example, a company such as Apple is in a better position to drive change than one of its smaller suppliers. Traditional 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.

Comparing 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 accruing in a supply chain. Knowing whether 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 positive change in its supply chains.

Social: nurturing talent

Since 1975, the share of intangible assets to the total market value of the S&P 500 has risen from 17% to a staggering 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, one of Google’s most valuable intangible assets is its search algorithm, and for Facebook its stores of data. Reckitt Benckiser’s Nurofen brand and the patents on Johnson & Johnson’s immuno-oncology therapies are both hugely valuable assets. These intangible assets are the products of human intelligence and creativity. Therefore, a workplace that can attract and retain great minds is of immense value.

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

Can a company retain and develop talent? You can build a picture by looking at things like 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 factor, yet the 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 discuss this further in using culture to reshape capitalism.

We only have to look at the current context 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 companies 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 significantly and quickly into several initiatives to keep their staff safe. In addition to pouring over US$4bn into employee safety each quarter³, and enacting over 150 new operational policies⁴, the company has now developed its own in-house COVID-19 testing capacity - not taking away from national capacity.

It can now test over 50,000 employees every day – reducing the number of absences. This means that an Amazon employee is 43% less likely to contract COVID-19, compared to the wider US population⁴. Not only has Amazon remained operational throughout the pandemic, it’s also increasing its workforce by over 400,000⁵ and generating over US$1bn of revenue a day⁶.

Governance: structuring for success

Effective 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 happens without effective governance.

You can learn a lot from the compensation structure of a company’s leadership when seeking to understand its priorities around ESG factors. An analysis of leadership structure can also highlight a company’s true intentions behind driving ESG quality. For instance, 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 vital part of the investment due diligence we carry out on all of the companies we look at within our sustainable strategy. This additional 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 important to both companies and investors.

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