Three lessons from three years of sustainable investing in Europe
Three lessons from three years of sustainable investing in Europe
Over the last three years we’ve reached a tipping point in the relationship between society and the companies we invest in. The idea that a profit-making enterprise can be pursued regardless of its impact on people or the environment has been so robustly challenged that it now seems outdated. Our capitalist economy is carefully shifting from commercial to conscious.
As managers of our clients’ capital, we need to interpret this tipping point and the opportunities and risks it presents to businesses. How we do this is crucial in our assessment of future value creation.
To help us make this assessment, Schroders has developed two digital tools, SustainEx and CONTEXT. They're explained at the bottom of this article, but broadly, SustainEx measures a business’s positive or negative impact on society, while CONTEXT considers the opportunities and risks thrown up by its relationships with its stakeholders.
These two tools enable us to integrate sustainability into every stage of our investment thinking. But the “secret sauce” of sustainable investing lies not in an output, but its interpretation. The shades of grey around tricky cases where a single score or number is simply not sufficient.
Still, these tools have helped us draw three crucial lessons about sustainable investing from our experiences over the past three years. These are:
- 1) sustainable investing can absolutely extend beyond best-in-class companies;
- 2) the environment is an important factor but not the only factor to consider in ESG investing; and
- 3) that we can (and must) use our position as stewards of capital to enact change.
Sustainable investing extends beyond “best-in-class”
One example of how our sustainability tools help uncover companies that do not start as best-in-class is through our research into Swedish hospital equipment and life sciences provider, Getinge AB.
When we first looked at the company in early 2020, our tools gave us a rather mixed picture. Getinge screened positively in SustainEx through the strength of its medicine provision and salaries, but well below average in CONTEXT compared to peers. This mainly reflected the company’s poor track record with the regulator under a previous management team who had been aggressive on cutting costs.
To gain a better understanding, we spoke with Getinge’s Head of Quality and Regulatory Compliance. We learnt that not only had a warning from the US Food & Drug Administration over quality control issues been addressed, but an entirely new set of quality standards had been integrated throughout the organisation.
In turn, these new quality standards formed the basis of a re-engineered business structure that helped reduce waste and increase efficiency in production processes. It also resulted in a new investment decision-making process that re-focused the business on higher growth areas.
This was a ‘light bulb’ moment for us, where a sustainability risk had morphed into a mispriced opportunity. We felt the cultural improvement and organisational change had not yet been fairly reflected by the market.
It is at these types of junctures in a company’s development where we strongly believe that the framework and flexibility of our process can unearth the greatest potential for returns. It also reinforces our belief that sustainable investing should not be limited solely to best-in-class companies. Those going through transition, periods of innovation, or delivering on material change can offer investment potential too.
ESG is about more than the E
Another area of the sustainability debate where we feel our tools give us an investment edge is around the balance of the E, the S and the G of environmental, social and governance.
It is no surprise that the more measurable and visible topic of the environment tends to dominate sustainability conversations both in markets and around dinner tables. However, we maintain a rounded investment approach that takes into account social and governance factors. This prevents one topic from trumping another and enables a focus on what is most relevant to a particular company.
We would not assume that a strongly-governed or socially-aware company must therefore have a positive environmental footprint. And similarly we must not fall foul of thinking that a company with a positive environmental footprint would automatically excel in its social or governance practices.
Take wind turbine manufacturers. Their environmental credentials are second to none in terms of their role in the transition to clean energy and delivering on avoided emissions.
But when reviewing these companies with regards to all stakeholders, some potential red flags came up. These included challenges around consistent quality control and future warranty costs, as well as supply chain and raw material difficulties. In some cases, unproven management teams were a concern.
Investing is piecing together a mosaic: materiality and context matter. The crucial point is that our tools flagged these issues, allowing us to make an informed decision.
This is by no means to belittle the importance of environmental issues in the sustainability debate, but to recognise that there is more to sustainability than the environment alone. The ESG debate is constantly evolving, as witnessed during the pandemic when the fragility of labour and supply chains have been brought to the fore.
Above all, we think a laser focus on valuation is what underpins every successful investment decision, sustainability-focused or otherwise. This is the case no matter how critical a company appears to be to the outside world.
Engagement drives change
Another area in which we feel we can add value for our companies and our clients is our ability to enact change through engagement. There is plenty more work for us to do here.
We can harness the granular output of our sustainability tools to form the basis of truly targeted engagements with companies. These could address a range of topics, from corporate strategy and remuneration to climate change and human capital management, as well as reactions to controversies.
An example of this would be Volkswagen, the German car manufacturer that succumbed to a governance crisis in 2015. This emerged as the “dieselgate” scandal, which unearthed a host of unsustainable practices throughout the company.
The road back for Volkswagen has been long and challenging, but the point of maximum pain can be the point of maximum change. Our analyst team has been closely monitoring progress and engaging at each stage of Volkswagen’s journey to encourage positive change and help enable the transition from past risks to future opportunities.
Some of the changes we have tracked are as simple as allowing company whistle-blowers to make complaints in a language other than German. Others are as complex as managing their plant facilities in Xinjiang, China; re-training their entire workforce from a mechanical to an electrical production line in a world of electric vehicles; or choosing to restructure and sell non-core assets.
This level of engagement takes time and manpower. We feel our process has been far more thorough and forward-looking than those of the third-party sustainability metric providers who tend to over-emphasise the past and are therefore slow to reflect change. This provides us with an edge so we can move ahead of other investors and capitalise on the subsequent change in market perception.
The challenge in engagement is always striking the right balance. We have to focus on what is most material to the company, and can therefore deliver the most meaningful change, while also ensuring all potential avenues for future controversies are covered in depth.
Clearly we will make mistakes and not all engagements will amount to change. But our mindset is one of learning from past experiences and putting them into practice in future engagements to help us form better investment decisions.
Schroders uses SustainEx™ to estimate the net impact of an investment portfolio having regard to certain sustainability measures in comparison to a product’s benchmark where relevant. It does this using third party data as well as Schroders own estimates and assumptions and the outcome may differ from other sustainability tools and measures.
CONTEXT considers the sustainability of a company’s business model having regard to certain measures and uses both third party data and our own estimates and assumptions and is not an industry standard measure.
The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored.