Sustainable Investing: Finding the Right Balance - Causeway Newsletter
Recently, clients have asked us how we evaluate companies from an environmental, social, and governance (ESG) perspective, and how this affects our decision making. The call for a focus on sustainability has become even more prevalent overseas. Some foreign plan sponsors have suggested that investment managers embed ESG requirements in the investment process, perhaps through explicit factor screens. In a show of support, many of the world's largest investment management firms have signed the United Nations-backed Principles for Responsible Investment. These firms vow to incorporate ESG criteria into just about every aspect of their work, with the Principles as the overall investing compass. Once signed, an asset management firm wears the halo of a "responsible" investor. Unsurprisingly, signers are proliferating, pens poised. Who wants to be labeled "irresponsible"? Sounds terrible. Causeway considers ESG factors that we think will affect a company's stock price when we are selecting stocks for client portfolios in our international and global value investment strategies. Yet, we have not signed the broadly-drafted Principles. Instead, we continue to take a subjective approach to evaluating ESG criteria as part of our intensive, bottom-up research process. That being said, if a particular client of Causeway desires to apply explicit ESG guidelines and restrictions to its portfolio, we can design customized screens or abide by restricted stock lists. We do this regularly for our socially-responsible-investing client mandates, which have been successful for our clients over longterm periods.
ESG principles and the entire concept of sustainable investing make sense. We believe the markets reward corporate responsibility over the long term. From our beginnings as a research team, we have habitually shunned companies with inadequate corporate governance, unethical practices, and any other corporate behavior we believe interferes with the best interests of shareholders. Our team makes these decisions case-by-case in the context of the industry, region, and maturity of the company, and any cultural, political, and societal reasons that may explain management's decisions. The utility of comprehensive ESG screens applied on an absolute basis is still up for debate. For example, the FTSE4Good Global Index, endowed with the longest track record of any of the ethical-company benchmarks, has struggled to keep pace with the MSCI World Index. Over the past decade, $100 dollars invested in the World Index, without any constraints, would have grown to $133, versus $119 for the sustainable benchmark.
We have a record of demanding better treatment for shareholders, such as the return of surplus capital, and expect our portfolio companies to operate at the highest level of integrity and disclosure. We spoke to Causeway fundamental portfolio managers Jamie Doyle and Jonathan Eng about their experiences with ESG criteria.
Jamie, clients increasingly ask if Causeway's ESG processes and polices are documented. They also want to know how Causeway measures adherence to ESG criteria.
JD: In the corporate governance category, we have detailed and documented proxy voting policies and procedures. Many of the corporate governance transgressions I've seen in my career are buried in the proxy. Causeway uses an experienced third party advisory firm, ISS, as a resource for proxy research to assist us in voting. Also, before our team can include a stock in client portfolios, we must convince ourselves that management is working for shareholders. This sounds simple, but assessing management's focus on shareholders takes a lot of effort. Where a client gives us the right to vote the proxy on its behalf, we cast votes consistent with responsible governance principles. Furthermore, our portfolio managers communicate regularly with senior management of portfolio companies. The following principles underpin both our conversations with management and our proxy voting policy:
• Increasing shareholder value
• Maintaining or increasing shareholder influence over the board of directors and management
• Establishing and enhancing a strong and independent board of directors
• Maintaining or increasing the rights of shareholders
• Aligning the interests of management and employees with those of shareholders, especially in areas such as executive compensation and shareholder dilution Some of our Japanese companies seem more reticent than their Western peers to respond to shareholder requests. My colleagues and I have sent letters to boards of directors over the past few years. Typically, we ask the company to return more surplus capital to shareholders and avoid dilutive acquisitions.
What is your commitment to encourage environmental awareness in the companies identified by your fundamental research?
JE: Let me take the chemicals industry as an example. Companies that have significant pollution problems normally don't make it through our research process. This is because we use strict financial strength criteria, and the dark cloud of potential (or ongoing) litigation, reputational damage, and community backlash can set the stage for a poor investment. We are on the alert for reputed problems that may (or may not) lead to societal and environmental damage that will hurt share prices. Our 360-degree analysis of businesses reveals all the information we can obtain from the company and its customers, suppliers, and competitors, not to mention local regulators, if applicable. We often interview former employees, whose livelihood no longer rests on the company's reputation. I think it's our job to find the right balance between ESG and superior investment performance. For example, one of our large European holdings, a paints and coatings manufacturer, has ranked in the top three in the chemicals supersector of the Dow Jones Sustainability World Index since 2007. The company's Sustainability Director stated its corporate ethos succinctly, "For us, business is sustainability and sustainability is business." We like that quote, and we find it useful to keep in mind in our research meetings.
How can you determine if the company's integration of sustainability efforts in its operations has reduced the risk of the stock?
JD: It's very difficult to quantify how much a company's cost of capital has benefitted from its efforts to be a model corporate citizen. If a company avoids costly operational mistakes, the fundamental risk of the stock over time is going to be lower than the risks of peers less oriented to sustainability. At the same time, we also expect a more stable share price pattern from consistent and shareholder-friendly corporate governance. Our weekly value screens bring us undervalued candidates. Then the work really begins, as we determine the quality of the company and balance sheet and earnings recovery, and engage with management to review any issues we see, including ESG risks.