Investing sustainably and profitably

By 9 minute read

There is currently a tidal wave of demand across the investment industry for solutions that either incorporate, or explicitly focus on ESG factors. Many investors have moved on from the outdated view that investing sustainably and profitably are mutually exclusive concepts and that responsible investing carries a performance cost.

Research like that shown below demonstrates that there are positive links across all three factors: environmental, social and governance.

Source: Friede, Busch, Bassen (ESG & Corporate Financial Performance: Mapping the global landscape). September 2016.

We believe sustainability analysis can be an effective source of investment alpha as part of a disciplined investment process:

  • Sustainability factors can have a direct impact on a company's near-term operational performance and long-term strategic positioning. Simply put, making and selling a damaging product and being irresponsible in how you do it is ultimately likely to destroy shareholder value, whilst doing the opposite can generate significant alpha.
  • Sustainability factors are often ignored or demoted during 'traditional' fundamental analysis in favor of more tangible financial factors. In essence, there is the potential for unappreciated and unharvested alpha here.
  • Traditional fundamental analysts are poorly trained or educated around what sustainability analysis really is, basing their opinions on the (false) positives and negatives they have experienced from third-party ESG screens.

Creating a sustainable equity portfolio

Our sustainability research process draws on both our fund managers' and ESG research team's extensive experience in order to translate our beliefs into a high conviction portfolio of innovative and disruptive companies. Our sustainability research process consists of two key stages: exclusions and bottom-up analysis.

Step one: Exclusions
Sustainability issues are rarely black and white. We therefore like to keep an open mind and to analyze and challenge the material sustainability issues facing a company from the bottom up, rather than being overly reliant on exclusionary screens.
That said, we recognize that there are certain products that our clients would never want to be associated with and so our exclusions, which have been developed in consultation with clients, prevent investment in the following: tobacco, weapons, nuclear power, gambling, mistreatment of animals, adult entertainment, genetic modification for agriculture and the extraction of oil, gas or coal. In practice, this excludes only around 15% of our global investment universe, leaving thousands of stocks still to consider.

Step two: Bottom-up analysis
Once the investment team have identified an idea for further research, the bottom-up fundamental analysis starts, using our FVT ('fundamentals, valuation, technicals') analysis framework. At the same time, the ESG research team will begin their assessment of the company, focusing on what we call the 'three dimensions of sustainability': product, practices and improvement:

  • Product: The nature of the products and services that a company provides ('what a company does')
  • Practices: Its operational practices and standards ('how it does it')
  • Improvement: Whether it has a track record of improvement or has meaningful ambitions to establish one. We track positive and negative sustainability changes.

Materiality is key to our sustainability analysis. Our focus is on the things that we believe really matter for each company under consideration. Material sustainability issues vary by sector and often within sectors, but a focus on materiality is critical in linking sustainability to any investment process.

The output of this three dimensional sustainability analysis is that companies are categorized as a sustainability Leader, Improver, or Laggard.

  • Leaders: Companies that meet a large amount of our absolute sustainability criteria and are demonstrably leaders in their sub-sector.
  • Improvers: Sustainability issues have been identified but the company is showing clear evidence of significant improvements in its sustainability performance.
  • Laggards: A combination of poor performance on products and practices and/or a lack of evidence of steps to address this.

The fund only invests in companies classified by the ESG research team as sustainability Leaders or Improvers.

For those companies identified as sustainability Improvers, sustainability KPIs are identified and tracked over time in order to ensure our classification is correct and inform our engagement with the company. The ESG research team can upgrade or downgrade a company during subsequent reviews based on these KPIs and if a holding is downgraded to a laggard then it must be sold from the portfolio.

Conceptually, we map our approach in the following way, using the three dimensions framework to categorize ideas as leaders, improvers or laggards.

Source: Kames Capital

The importance of identifying sustainability improvers

In our view, funds that focus only on investing in sector sustainability leaders have a number of limitations. Firstly, they are likely to heavily restrict the investment universe (by definition, not every company can be a leader). Secondly, they may face biases and factor risks along quality (high), region (developed markets) and market cap (large) lines, meaning returns are more likely to be driven by these broad factors than by individual stock selection. Finally, by considering only leaders, an investor potentially risks missing out on smaller disruptive companies that are providing innovative sustainability solutions.

Understanding whether a company is improving its sustainability performance is therefore key. Sustainability momentum is a useful proxy for fundamental improvement and should in turn be reflected in a company's valuation. The idea of investing in sustainability improvers is also supported by empirical research.

Source - Financial Performance of ESG Integration in US Investing, Nguyen-Taylor, K & Martindale, W (2018). Table Source: MSCI ESG Ratings (ESG Ratings data: MSCI ESG Research 2007-2017) and MSCI Index data (ESG Index data: MSCI Inc. 2007-2017)

In practice, we find that these 'improvers' are often disruptive and innovative companies. Many are in the hugely diverse healthcare, technology and industrial sectors and are using and embracing rapid technological change to address sustainability issues. Capitalizing on advances in medical care, increased automation, high-precision and efficient manufacturing and material recycling as part of the 'circular economy', these disrupters are likely to be younger and smaller companies than the incumbents they challenge, sometimes located in emerging markets where many of the world's most material sustainability issues reside. Our bottom-up process is focused on identifying these problem solvers at an early stage of their development and if necessary engaging with them as they grow. This should help to instil a sustainable mind-set into their growth so that they can become both sustainability and market leaders.

Simplicity, transparency and differentiation

In 2016, we launched the Kames Global Sustainable Equity Fund that builds upon our 30 years of experience running ESG-focused equity strategies. We are passionate advocates for responsible investing and we have a simple mantra for this fund: we want it to be the best performing global equity fund in the market and we want to do this by investing in stocks with strong sustainability characteristics. Specifically we believe we have a unique and differentiated way of investing sustainably.

  • A concentrated portfolio with a high active share: We back our abilities as bottom-up stock pickers by running a concentrated portfolio of 35-40 stocks where each stock can make a meaningful contribution to fund performance. Our fund is more concentrated than many of our peers and offers a genuinely differentiated set of holdings, with an active share of over 99% versus the MSCI ACWI.
  • A focus on mid-cap growth: We find that many of the most promising companies providing innovative and disruptive solutions to the world's sustainability challenges are relatively young and fast growing. As a result, the fund has a prominent mid cap growth bias, which differentiates it from the large cap quality approach that many other ESG-focused funds often take.
  • ESG leaders and improvers: Companies that score highly on material ESG factors have been shown to outperform the market but companies that have improving ESG scores can outperform to an even greater degree. We invest in sector leaders but also seek to identify and invest in companies whose sustainability performance is changing.
  • Understanding that the ESG truth is in the nuance: Due to its qualitative nature there will always be debates, grey areas and nuances, which is why the topic, quite simply, must be approached from the bottom up. Our independent ESG research team carries out bottom-up sustainability analysis on each stock considered for the fund, alongside the traditional financial analysis carried out by the fund managers. This adds an extra layer of robustness to our process and helps produce a more holistic understanding of the company's risks and opportunities.

Sustainability factors can have a direct impact on a company's near-term operational performance and long-term strategic positioning. We consider the sustainability of 'what' a company does, 'how' it operates, and improvement or how its sustainability performance is changing over time. Investing in both sustainability improvers and leaders provides a number of advantages over a best-in-class approach.

Iain Snedden

About Iain Snedden

Investment specialist Equities