There is currently a surge 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 Many investors have moved on from the outdated view that investing sustainably and profitably are mutually exclusive concepts and that responsible investing carries a performance cost.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.
Research shows positive association between ESG factors and corporate financial performance
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.
Creating a sustainable equity portfolio
Our sustainability research process draws on both our 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.
Annualised excess returns to select ESG Rating portfolios 1993 through 2014
Source: Khan, Serafeim, and Aaron Yoon (2015). Past performance is not indicative of future results.
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.|
All investments contain risk and may lose value. The identification of 'leaders', 'laggards' and 'improvers' is based on Kames assessment of a company's sustainability of its products and practices. There is no guarantee that the assessment of a company as a leader or improver will continue or that positive results will be obtained from investment in securities of such companies.
The strategy 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, strategies 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. We believe that sustainability momentum can serve as 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.
ESG: Absolute ('Tilt') and Improvement ('Momentum') Strategies
Active Performance vs. MSCI World Index
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). Past performance is not indicative of future results.
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 strategy 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 strategy: we want it to be the best performing global equity strategy 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 where each stock can make a meaningful contribution to performance. Our strategy 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 strategy 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 strategy, alongside the traditional financial analysis carried out by the managers. This adds an extra layer of robustness
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.
Detailed sustainability analysis as part of the fundamental investment research we undertake allows us to invest with conviction in a concentrated portfolio of 35-40 stocks with a high active share.
For Kames Capital plc is an SEC registered investment adviser. Please refer to Kames Capital's Form ADV Part 2A which is available on the Investment Adviser Public Disclosure website (https://www.adviserinfo.sec.gov/). In the event that any content within this material conflicts with Kames Capital's Form ADV, the Form ADV takes precedence.
Past performance is not indicative of future results. This material is to be used for institutional investors and not for any other purpose. Nothing within this material is intended as a recommendation, research or advice and no representation as to suitability for any particular investor is being made: investors should consider their own need for advice prior to making an investment decision.
Neither Kames Capital plc nor Aegon Asset Management US are undertaking to provide impartial investment advice or give advice in a fiduciary capacity for the purposes of any applicable federal or state law or regulation. By receiving this material, you agree with the intended purpose described above. Results for certain charts and graphs are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions.
Any 'forward-looking statements" are based on Kames Capital's beliefs, as well as on a number of assumptions concerning future events, based on information currently available to Kames. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Such statements are not guarantees of future performance which may differ materially from statements within.
Opinions expressed represent our understanding of the current and historical positions of the market and are not an investment recommendation, research or advice. Any securities and related trading strategies referenced may or may not be held/used in any strategy/portfolio. Any Opinions and/or example trades/securities are only present for the purposes of promoting Kames Capital's investment management capabilities. Sources used, both internal and external, are deemed reliable by Kames Capital at the time of writing.
There is no guarantee that these investment or portfolio strategies will work under all market conditions and are suitable for all investors and each investor should evaluate their ability to invest over the long term, especially during periods of increased market volatility. Social responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised, by any company of Aegon Asset Management will reflect the beliefs or values of any one particular investor.
Information regarding responsible practices is obtained through voluntary or third-party reporting, which may not be accurate or complete, and Aegon Asset Management is dependent on such information to evaluate a company's commitment to, or implementation of, responsible practices. Socially responsible norms differ by region. There is no assurance that the socially responsible investing strategy and techniques employed will be successful.
There is no guarantee that socially responsible investing (SRI) products or strategies will produce returns similar to traditional investments.
All data is sourced to Kames Capital unless otherwise stated. Data attributed to a third party ("3rd Party Data") is proprietary to that third party and/or other suppliers (the "Data Owner") and is used by Kames Capital under licence. 3rd Party Data: (i) may not be copied or distributed; and (ii) is not warranted to be accurate, complete or timely. None of the Data Owner, Kames Capital or any other person connected to, or from whom Kames Capital sources, 3rd Party Data is liable for any losses or liabilities arising from use of 3rd Party Data.
The document is accurate at the time of writing but is subject to change without notice. Whilst care has been taken in the preparation of these materials, its accuracy is not guaranteed and it does not form the basis of any subsequent contract.
AUIM is the appointed solicitor and acts on behalf of Kames Capital plc with respect to the promotion of Kames Capital's strategies to US based Institutional Investors. AUIM is a US based registered investment adviser with the SEC. Kames Capital plc is a registered investment adviser with the SEC.
Kames Capital plc is authorised and regulated by the Financial Conduct Authority. FP2020/8590 AdTrax: 2984206.1. Exp Date: 2/28/2022.