It's all in the mixing ESG integration increasing the investment case for businesses

 

Research on the effectiveness of governance (G) as an indicator of investment outperformance has confirmed that there are general correlations between the two. The most famous example is the so called CalPERS (California Public Employees Retirement System) effect, which is still valid even though corporate governance has generally improved over the years.

The results showed that, in the 1980s, when CalPERS started taking governance seriously, investee companies, as a collective, began outperforming other S&P 500 companies by 15%.

The importance of the social (S) is clear when discussing the Marikana massacre one year on. Ann Crotty, in the Business Report of 16 August 2013, made this comment on mining companies operating in the vicinity of Marikana: "Since the early 1970s, hundreds of thousands of people have been shipped into the area to provide labour for mines. Despite the evident long-term nature of mining activity, the three companies operating in the area have adopted a continuous short-term approach to their labour needs, seemingly too fixated on generating returns in the current six-month reporting period to undertake appropriate long-term investment.”

Environmental (E) questions can be just as damaging to a company’s reputation. Even though it claimed that it did not do anything unlawful, Coal of Africa, in mining coal next to the Mapungubwe world heritage site, received significant negative publicity, which did not endear them to a number of stakeholders.

One of the main functions of ESG policies is risk mitigation. By exploring ESG issues, the company takes a wider view of business risks. Sustainability issues cannot just be something published in an annual report and necessitate a broader vision of how the company fits into the socio-economic framework within which it operates.

The first steps towards ESG investing did not involve integrating ESG into the investment process, but rather establishing investment funds which used positive or negative screening as a basis for investment decisions. With positive screening, only companies with high ESG scores are used in the investment universe, while negative screening companies with low ESG scores are excluded.

Another approach is to use index funds, which by their very nature, are the mandates most commonly used by larger retirement funds. As these usually represent larger blocks of shares, the idea is to use the holding for aggressive corporate governance rather than to sell out the shares in protest. The most prominent fund using this route is the GEPF/PIC.

While the techniques used above can be described as a sort of ‘first wave’ of ESG integration, they still treat ESG as something separate from normal investment practice. More recent practice, however, incorporates ESG factors as one of the inputs into the investment process.

 

The stock selection part of the equity investment process aims to identify companies in which large overweight or underweight positions are held. In determining these companies, the use of a holistic, three-pillar approach which incorporates the (1) valuation of the company, (2) ESG and quality considerations and (3) investment themes the company is exposed to, becomes necessary.

Where there are important issues which will elicit negative votes, company management becomes the focus of an engagement process. This practice also applies to identifying ESG issues, which need to be addressed by the company, but which may not be encapsulated in specific resolutions at shareholder meetings.