ESG integration plays an important role in compounding performance returns, with material ESG factors, such as company risk management, now having the ability to threaten the future returns of a company.
It’s increasingly apparent that the companies that are able to integrate ESG across their business in a tangible, measurable way, are more likely to be quality long-term stocks for investors.
How investors go about assessing and selecting companies based on ESG factors has started to become much more sophisticated, and there are a variety of options available to them.
While more basic screening processes can aid in the exclusion of tobacco, alcohol and weapons, for example, in the short-term, in order to take a longer-term position at both the sector and stock level, there are other risk factors warranting consideration.
Company management is an obvious yet critically important factor for investment managers to consider, and can most adequately be assessed with engagement. Through open dialogue with the company directly, investors are able to determine how management reinvests back into the business and avoids wasting money on poor acquisition decisions, for example, and ultimately, ensure that strong earnings are sustainable.
In its engagement program, Morgan Stanley reviews company reports, liaises with stockbrokers, and also uses third-party ESG reports to assess any future ESG risks. It then directly engages with company management in ensuring the stock remains part of the holding.
For example, recent engagement with the management of French-owned L'Oréal, the world’s largest cosmetics company, proved invaluable.
With a high proportion of younger, female consumers increasingly concerned about the environmental impact of its products, the company committed to a new strategic path. It has dedicated substantial resources into more sustainable packaging, and there are encouraging statistics on its innovations in making their products less harmful to the environment. L'Oréal is also now trialling new labels to demonstrate how they’re progressing with these changes, which will be welcomed by both regulators and consumers. The transition will also likely assist the company to gain market share from competitors in the space, making the stock infinitely more attractive to investors as a result.
It stands to reason that if we had not sought formal engagement with the management of L'Oréal, arguably this transition may not have eventuated. Being in a position to talk to companies about reducing their carbon footprint at a practical level is a means for asset managers to make a tangible difference.
As part of this, proxy voting has also become more pronounced for asset managers, and it’s another opportunity for managers to use their position to the benefit of all shareholders.
As active owners, one of the advantages of owning a stock is having this level of access. We can determine whether company boards have sufficient risk control practices in place, for example, and use our vote accordingly.
A structured approach to company engagement should focus on dual discussions with the senior management as well as sustainability representatives of investee companies. This structure of engagement provides useful insights, especially regarding company responses to and priorities during the pandemic.
Within this, incorporating a systematic approach to management incentives has become more profound through the coronavirus pandemic, with the ability to compare and discuss company pay plans helping underpin proxy voting decision-making.
Efforts to engage are helped by long-term holdings of significant stakes in companies. The resulting access makes asset managers less dependent on news presented at public annual general meetings or investor relations events. Reserving the hardest questions for private meetings, not the podium or the press, is also more likely to garner thoughtful consideration of an asset manager’s position and drive the agenda of future engagements.
Over the past year, the restrictions of COVID-19 have meant digital and videoconferencing have facilitated company engagement. While most companies were receptive to this format, it has made engagement on some more sensitive ESG topics, such as decarbonisation and diversity, more challenging. Nonetheless, the industry at large has slowly resumed the preferred method of engagement – face to face.
Globally, the call for greater transparency and disclosure of companies’ and fund managers’ activities, as well as in-depth portfolio reporting, is finding its way into regulation. As the investment management industry navigates the ESG journey, it pays to avoid a faddy, tick-the-box approach, and instead, maintain investment discipline, focus on robust stocks and commit to long-term, meaningful company engagement.
Bruno Paulson, portfolio manager, Morgan Stanley Investment Management
