ESG investments

Alistair: We have found that those companies that take their ESG responsibilities seriously tend to adapt better to the risks and opportunities that they face and conversely those companies that are unsustainable, by nature tend to be found out. When risk aversion returns to equity markets there is always a flight to quality, which benefits these sustainable companies to the cost of those companies that are not.  

There are a lot of opportunities in the consumer sector where companies are looking at more nutritious products, more sustainable packaging and improving water and energy usage. Technology will also play a big role in terms of manufacturing efficiency, better inventory control, more sustainable raw material production to name just a few.

Nachu: We do not see financial and sustainable investment objectives being mutually exclusive. We believe that they are two co-linear objectives that are self-reinforcing: sustainable companies or assets strengthen financial and operating profiles, which in turn supports investment performance.

The case is true for the global high yield market, in which stewardship plays a key role. Relative to large, investment grade companies, high yield firms are often under-engaged and have less advanced sustainability strategies. This allows us to identify and then engage with companies who have the willingness and ability to change their operations that can benefit society and the environment. Some of these companies may not yet be focusing on creating positive change, but this enables us to play an important role in their efforts to become impactful and continue to seek attractive returns for our investors.

John: We believe we have a higher probability of outperforming if we understand a company in the context of all of its stakeholders – which is what a fundamental investment approach that incorporates ESG helps us to do. ESG analysis provides additional insights into a company’s business model and culture, including whether it has a competitive market position, which in turn may help us analyse potential revenue growth, business risks and returns.

At Ninety One, we see decarbonisation as a particularly exciting area of long-term structural growth, and one that is opening up a diverse range of investment opportunities. The key pathways to a low-carbon future include renewable energy, electrification and resource efficiency, and across all of them, there are some exciting companies enabling decarbonisation that we think have tremendous growth potential. One of our investment strategies focuses specifically on decarbonisation, using a proprietary screen to identify companies with the potential to benefit from this multi-year transition. Managed by an experienced team committed to environmental change, the resulting portfolio is diversified by sector, technology and region.

Harry: Enhanced ESG analysis allows us to understand a company beyond its financials, helping us to avoid hidden risks and capitalise on underappreciated opportunities. By incorporating differentiated and financially material ESG insights into our analysis, we believe we can generate even stronger risk-adjusted returns for our clients. TT’s investment process includes our proprietary ESG screen, where we compare a company to its sector and geography in terms of overall ESG perception, controversies, governance risk, carbon intensity, physical climate risk exposure, and social risk factors. We aim to understand material ESG issues that have investment ramifications to incorporate them into our valuation process.

If we are considering investing in companies that have previously encountered ESG controversies, we look for evidence of accountability and cultural change. We also monitor significant ESG controversies in our portfolios on a real-time basis.

On the opportunity side, we actively screen our investment universe for companies that provide solutions to climate change and environmental degradation. Given the growing recognition of the vital importance of helping to solve these existential threats to the planet, we believe that environmental equities as an asset class are likely to be a segment of the market that will see secular outperformance for many years to come. We believe that the market has yet to appreciate the scale of the transition required, given that it will impact a huge number of areas, including energy generation, travel, building, diet, agriculture and clothing. Much of our peer group have a more narrow focus on carbon and other greenhouse gases, whereas our approach has been designed to consider all harms to nature and is particularly focused on biodiversity. A popular Chinese proverb states: “The best time to plant a tree was 20 years ago. The second-best time is now.” We believe the same can be said of environmental investment.

Some of the most exciting themes in our Environmental Solutions Fund are:

Insulation – We expect this theme to accelerate in the US due to building code reforms in 2021 and Biden-related stimulus. New building codes will require single-family homes to have significantly more insulation when they are built. We have US exposure through Installed Building Products and Owens Corning, as well as European exposure through Rockwool and Steico. 

Grid storage – As renewables become a higher proportion to the overall energy mix, more sophisticated grid storage options will be required to mitigate the problem of power production intermittency. We have exposure through Invinity, Sungrow Power, which is one of the world’s largest producers of grid-scale battery modules, and Terna, which has a large pumped hydro growth project.

Electric Vehicles – EVs and hybrids are now outselling diesel vehicles in Europe and penetration data has generally been very encouraging. Whilst many direct EV plays have become a bit stretched from a valuations perspective, we have good exposure to the EV supply-chain through Infineon, Delta Electronics, Akasol and Hansol Chemical, where we are still able to find plenty of very attractive upside.

Alistair: By definition, the highest quality companies have the strongest ESG profiles, but those companies recognise that complacency is a significant risk, and therefore they recognise that they cannot stand still, so in effect these companies are improving. From time to time when there are changes at the senior management/board level or where there is a change of ownership and this results in more focus on ESG then these companies can also enjoy higher returns. We see several Japanese companies that display these characteristics. As a portfolio manager it important to have a blend of the two, whilst remembering that straying too far down the quality curve can prove to be costly.

Nachu: We believe there are financial performance opportunities to be harvested by investing in future sustainability leaders. Given secular trends there does appear to be elevated demand for climate-change leaders currently, which is making some of these companies bonds overbought and look expensive on a relative value basis. We think investing in credible laggards with engagement or transition leaders makes financial sense as they are likely to become the “screened-in” leaders of the future and we can then capture the alpha from them.

John: The first point to make is that we think it’s important to conduct our own research into a company’s ESG profile, because our assessments can be very different from those of external agencies. It’s also crucial to determine which ESG factors are material – i.e., which ones have the potential to meaningfully influence asset values – as this will vary between industries and from company to company. In this respect, we see ESG analysis as a potential driver of outperformance for active managers, because sustainability-related risks can be misunderstood or mispriced by the market, just like other types of investment risk.

There is no rule as to whether it’s better to invest in companies with ‘strong’ or ‘improving’ ESG profiles. A company that performs strongly from an ESG perspective may not be a good investment if its growth prospects are limited and/or its shares are overpriced. What matters is being able to assess and, crucially, price the risks and opportunities associated with ESG issues, and then to be able to balance these factors with other investment considerations. The key to doing so is to fully integrate ESG analysis into an investment process.

Harry: In the short term, companies with improving ESG profiles can get rewarded more strongly; however, when we look on a five-year basis, we see that the ESG champions have significantly outperformed the improvers in Asia. Therefore, although companies with improving ESG characteristics can prove to be excellent investment opportunities, we believe that investors should mainly focus on companies with strong ESG qualities, whether these are captured by ESG ratings or not. This is partly because the environmental thematic will likely be the defining structural growth opportunity for investors over the next two decades, and partly because companies with strong ESG qualities are more likely to avoid hidden ESG risks and associated liabilities, which continue to grow each year.

Alistair: I don’t believe so in an investment sense, as a continued focus on ESG is here to stay. Where investors might need to be wary of is where either companies or fund managers just pay lip service to ESG and simply take a box-ticking approach. Similarly, some areas of investing might be misleading e.g. The Dow Jones Sustainability index includes tobacco companies but tobacco is one of the least sustainable industries in the world.

Nachu: The ‘greenium’ will likely slowly erode as more supply comes to the market. Currently, there is a ‘greenium’ in the market but it is not dramatic, but it is an efficiency investors need to be aware of.

John: 2020 was a pivotal year in terms of the global focus on sustainability, spurred by Covid-19 and global commitments to tackling climate change, including net-zero pledges by China, Japan and South Korea. That provided a tailwind for many stocks perceived as being well-placed for the transition to a more sustainable economy, and also fuelled inflows into investment funds with a sustainability focus.

But while valuations look stretched in some areas of the market, we think there is still plenty of value and long-term growth potential in companies that are positioned to benefit from the growing focus on sustainability and from decarbonisation especially. In our decarbonisation equity portfolio, for example, valuations increased last year but only in line with the valuation gain in broad equity indices. And while several parts of the decarbonisation universe look expensive to us, other areas seem cheap, such as parts of the electric-vehicle value chain. This highlights the continued need for careful research and a highly selective approach to investing in decarbonisation.

Harry: 2020 was undoubtedly when ESG finally went mainstream. Over the year, more than $170bn flowed into ESG equity funds. The most widely held companies in these funds saw their valuation multiples expand dramatically, leading some to question whether there was an ESG bubble. However, many of these stocks have come in for significant profit-taking in recent weeks, removing much of the speculative froth.

We distinguish between ESG investing and thematic investments. Within TT’s Environmental Solutions Fund, we are often able to find investment opportunities that are geared towards the “green shift”, which would not be considered mainstream holdings within broad ESG funds. While there are areas of the market where valuations remain stretched, such as EVs and renewables, it is still very early days for many environmental technologies including solar, hydrogen and carbon capture, all of which have a long growth runway ahead of them. Moreover, TT’s Environmental Solutions Fund is actively managed to ensure we take profits in our best-performing stocks and recycle the proceeds into relative laggards. We also ensure that the portfolio remains well-diversified. It is not simply exposed to the most popular areas of the market, but rather has exposure to a wide range of themes including agriculture, water, forestry and recycling, which at this stage remain relatively underappreciated, in our view.