Episode 10: How ESG Enhances Analysis of a Firm’s Evolution and Future Prospects

Properly parsing a company’s internal ESG metrics alongside third-party data requires understanding the context and limitations of both data sets to better gauge the potential return.


How ESG Enhances Analysis of a Firm’s Evolution and Future Prospects

Charles Roth:    Hi.  Welcome to another episode of Away from the Noise, Thornburg Investment Management’s podcasts on key investment topics, economics and market developments of the day.  I’m Charles Roth, Global Market’s editor at Thornburg.  We’re joined today by Jake Walko, Thornburg’s director of ESG investing and Global Investment’s Stewardship.  Jake hails from Poland, came to the US as a teenager.  He started in finance actually a week out of high school at a family office in downtown Manhattan while studying at Hunter College, where he obtained a degree in economics.  He then went to the city college of the City University of New York and earned a master’s in international relations, focusing on international political economy, then spent 6 months at the United Nations working on conventional weapons disarmament; essentially security for humanitarian situations.  After his stint at the United Nations, Jake worked at Proxy Advisor Glass Lewis, and after his time there, joined Black Rock as an ESG analyst with the stewardship team covering tech and real estate.  He also spent time at Neuberger Berman as a vice president for ESG investing and Global Investment Stewardship.  Thank you for joining us today, Jake.

Jake Walko:       Absolutely.  Good morning.

Charles Roth:    Why don’t we start off by talking about what has changed that makes ESG analysis more decision useful than, than it was in the past.

Jake Walko:       Sure, and, and this, this is such a, such an exciting time for ESG which, which has, I feel, forever felt like being in it’s infancy, and for a long time, there were a lot of conversations around, you know, these topics being obviously interesting, or, or relevant to, to traditional fundamental analysis or certainly, anecdotally interesting where we would see failures at companies because of, uh, some sustainability dimension.  But what has changed in the last couple of years, i-is really that you are finally able to measure all the things that you couldn’t in the past, and also, measure in a way that is comparable across companies and over time.  So, what that means is, whereas in the past you could look at the, you know, the safety record of a company, or maybe its consumer relationships, it wasn’t easy to compare it to, you know, maybe the next vect year, which might have been a smaller company that didn’t have the disclosure, or maybe they were using different methodology.  So, the standardization in methodology, the more effective capture of data, much improved disclosure from companies themselves especially in different jurisdictions like Europe or, or Japan, has really created a decision useful set of ESG data that put in the right hands of people who are educated and informed about what these things are measuring, can really make sound investment decisions that were not possible in the past.

Charles Roth:    So, you mentioned, uh, Europe and Japan, where does the US stand on ESG integration at the corporate level?

Jake Walko:       I-i-it’s very interesting because for a long time, many American companies were at the forefront of, of disclosure and, and practices, and you definitely see something of a market cap bias.  Right?  Larger companies with international presence with many stakeholders, different shareholder bases, have been paying attention to this for, for a long time, even if they couldn’t quite find out, you know, which frame work should they be using or what they should be disclosing.  The, the US, especially in the small and new cap space, has a, a, in my opinion, not quite kept up with, with the expectations from any other markets largely as a result of that fact that regulation in Europe and, and in other markets has moved very aggressively forward.  And so, if you actually look at the, the amount of regulation both on issuers and on asset managers related to sustainability, it’s really coming to, into effect in the last two years only.  So, there’s a lot of companies that are, especially in the US, where the, where these regulatory environments are, are not as vigorous, are, are coming to grips with the fact that now if they want to operate over seas or if they want to sell their product there, they, they have to come up to standard.  And so, w-what, what it’s led to is, everything from sort of fact finding missions, where a lot of, you know, companies are reaching out to shareholders, and asking what it is that we want to see to, you know, uh, interesting innovation in putting out their own metrics, but certainly confusion and best efforts and something of a wild west, which, which really plays into the hands of managers who are able to differentiate between these things and read these things and, and infer something out of them.

Charles Roth:    It seems like on some levels, there’s a standardization but on other levels, there’s, there’s not. So, can you kind of describe the relationship between internal and external ESG ratings and assessments?

Jake Walko:       The standardization is something that has been really in the privy of the larger companies.  Companies that have maybe hired sustainability professionals who are able to identify which, which framework is suitable for them, how they should be collecting this data and start accumulating a track record of, you know, something like emissions, for example.  You do need to provide several years of that data for it to be useful to investors.  The big difference between internal and external ESG ratings, is really, I think, one of the most core and important elements of where ESG is today.  There’s a lot of credit to be given to, uh, the third‑party assessors of, of ESG and the providers of that data.  It is really impressive how much this data has changed over the last few years, as I mentioned before, and, and many of these things that are available to asset managers today, were unthinkable a decade ago.  The nature of the third‑party external data is that it needs to provide elements that are useful to many types of ESG.  And this, this is both a strength and a weakness.  It’s a strength in the sense that they endeavor to be very comprehensive, but it’s a weakness in the sense that when we think about different ESG strategies built by different managers, they aren’t all doing the same thing, and there are big differences between investing for clients that have specific values expectations or specific mandates that have political, you know, or, or social dimensions to, to what they are as entities and what they are required to do by the agreement with their trustees.  And maybe the, you know, it’s not quite the other spectrum, but a different version of ESG, which is a, a view on, on fundamentals, risk management, opportunity seeking, really trying to understand which companies are best positioned to, to be successful in the future.  And so, that’s where the internal assessments come in and are very important, because ESG data has been, I think at this point, very well studied and there are very clear cases of factors that are useful to company performance and risk mitigation.  But, they have to be in the right hands because many of these conclusions are applicable to specific markets, specific market caps, specific sectors, and so, it’s not all right to just overlay the data that you buy, you know, on some portfolio and say, this has suddenly become an ESG portfolio.  You have to understand what are the real implications of this particular conclusion from the regression of this factor on this particular type of company in the environment that it is operating in.  So, internal ratings bridge that gap.  They can create that, you know, that kind of modification to external data, they can take the raw data from, from providers and, and create our own scoring, methodology and framework, essentially moving the increasingly robust ingredients to a place where you can really make decisions on sizing, on investment or not investment, on hold period, those kinds of things that are really important to the actual outcomes in portfolio construction.

Charles Roth:    So, are you able to differentiate between those that are genuinely integrating ESG factors into their business versus those that only appear to be?  In other words, green washing, is it to the point where it’s pretty easy to identify companies that are talking the talk but not walking the walk?

Jake Walko:       I think it’s, it’s, it continues to be a, a challenge.  In, in many ways, this is why the, the engagement in the stewardship elements are so important.  One, one of the things that I think folks don’t quite appreciate is that fact that there has been a, a long debate as to the legal implications and liabilities of what companies put out in their materials.  There used to be a, an idea a while back that sustainability didn’t quite count the same way that, you know, a 10k disclosure would.  But, that’s really not consistently true across markets and increasingly, regulators have held companies to the same standard on, on any kind of disclosure that they’re providing, where they really need to mean the things that, that they say in sustainability reports.  In some ways, what that has created is a reluctance by companies to disclose ESG data.  In other places, it has led to greater rigor and greater internal scrutiny of, of what they’re disclosing, which is really the bit that we appreciate.  Right?  We want this data to be reliable and we accept the fact that there are sometimes revisions and imperfections and so on.  These things are difficult.  We’re all learning.  We’re learning how to disclose it.  We’re learning how to analyze it, but it is not yet quite easy to see who is doing a great job of being, being truthful and authentic versus those that aren’t.  That being said, I think a lot of this is going to come to light in the, in the next few years, where the kinds of questions that we are not able to ask companies can give us insights into how reliable this data is, where it’s going, what it means about the business operations, uh, of, of the company.

Charles Roth:    So, that, that brings up a couple interesting questions actually.  In terms of both active management and the ESG integration in the investment process and passive in which, essentially, com-companies that pass muster on the ESG criteria that the passive vehicle has established for inclusion in, in the, in the portfolio.  How can an active manager essentially identify those companies that rank low on ESG metrics, the, the standard metrics, but that are genuinely trying to integrate ESG, such that they have what’s called ESG momentum?

Charles Roth:    And, until you get in, essentially, before you become highly ranked on, on ESG metrics.

Jake Walko:       Yeah, so, so, I had, I had mentioned before that the-these things have to be in the right hands.  And one of the key things to understand about many of these both, uh, metrics that are disclosed by the company and also how these things are aggregated by the third‑party providers and ratings, is that, uh, many of these factors are backward looking.  And disclosure tends to take a while to come out.  Right?  If you’re looking at that emissions number, that emissions number might be six months old at best.  It may be a year and a half old, and it’s further looking at emissions that took place, you know, even more months and years into the past.  So, what that means is, if you were to do, if you were to perform a crude exercise where your screening companies on fairly unsophisticated factors, without that context and without adjusting the data in appropriate ways, what you will end up with is a portfolio of companies that have done something well in the past.  And that may not be a great indicator of what’s going to happen in the future, nor is it really a reflection of the, as you mentioned, the, the momentum story, which is, which is very compelling from the, from the prospective of companies that are quickly improving.  Right?  And so, a, if you look at the disclosure provided, much of it only dates back a few years, which means that many of the factors and the conclusions that you can draw from regressions don’t even have a full business cycle.  Which is, which is really challenging, right?  Because it begs the question of are these companies just riding the, the sort of the success of the last few years, both in their ESG performance and their actual performance?  Is it a correlation to growth?  Is there a market cap bias?  Is the better ESG in sectors with fewer inherent challenges?  You know, you can think about, sort of, technology in commercial services versus something at mining or energy, right?  Those are very different business where the management of the material issues in their spaces can be easier or harder depending on, you know, the kind of, uh, the particular challenges that, that they’re facing in any given time period.  And, and, so, what it means is these, these factors are really great for bias mitigation.  They’re a great snapshot, um, you know, to, to do something further with, but you really need to have that specific insight into the specific company and its context.  And so, the question that it, it further begs, from the perspective of a client is, what do you want this portfolio to be?  Do you want it to be a basket of the best performers in the past?  Or, do you want it to be best positioned for the future?  And if you think about companies that are going through significant transitions, those transitions are not often going to be reflected in the past performance.  So, you need to be able to look at that data that has come out to date, and then, modify it appropriately and make investment choices for what you know the company is trying to do in the, in the near future or the medium term.

Charles Roth:    So, you mention the miners.  That brings up a very interesting point.  Can a sensibly non-ESG company, say tobacco companies or miners or energy companies become more ESG and investable on that front?

Jake Walko:       I, definitely believe so. And, and so, there are going to be clients that will specify to, to us that they do not want to be involved in a certain area.  Right?  Which is perfectly appropriate.  It is something that asset managers need to consistently deliver on, right?  This is a big exercise of the relationship between asset owners and asset managers, but a lot of those kinds of values, judgments and sectors as a whole, need to really come from the client side because we can’t be making those kinds of judgments specifically on behalf of groups of clients.  Right?  There are many people who are interested in different types of investing.  That being said, within each sector, we are really looking at companies that are leaders versus their peers.  Right?  So, what it means is, um, even if you’re a mining company or a tobacco company, there will be times at which we will want to invest in these kinds of businesses, but when we do, we want to select the companies that are least risky and best positioned to take advantage of, of future opportunities.  And so, we will look towards that sustainability disclosure to understand are you a trustworthy player in this space where you have demonstrated that you are able to manage the challenges that are confronting your business, and will it position you well to, you know, secure license to, license to operate, uh, minimize the liabilities, be able to be a responsible participant, you know, in the businesses that you operate in and the, the communities that you operate in.  So, there’s a lot of dimensions to this, but I, I would definitely encourage companies to not think of themselves as, as operating in some sort of a, you know, a pariah, uh, element of business.  Right?  Let our clients make those choices.  Let us as investment managers allocate to the areas that we think is least risky and, and best positioned for the future, but the companies themselves just need to be providing great disclosure on material factors, improving their sustainability, thinking about how their business is, is positioned for the future and making capital deployment decisions that align all of those factors.

Charles Roth:    So, you mention the social and environmental values earlier, and, and I want to focus for just a minute on the G part.  The governance part of ESG and particularly in assessing corporate management.  So, it used to be gathering a feel for the integrity and competence of management, investors would, would, would speak with them, try to understand their record on resource allocation, strategy, execution.  It seemed very qualitative in, in, in nature, perhaps more than science.  Now, there are scores of criteria, many boxes that can be checked with respect to the governance part of the equation.  I-is it now more quantitative than qualitative?  Is, is there still as much art as, as science in assessing the quality of management?

Jake Walko:       I think the art of it is not going away any time soon.  What the art has become is more quantitatively driven, and what that means in practice is, it used to be that when you would asked questions of material factors of management, the only insights that you could really get was, sort of, how did you feel about that conversation, right?  The, the answers were usually we care about these issues.  You can trust us we’re managing these issues.  You know, this is important to our business, and we’ll continue looking at it.  Right?  These kinds of, perhaps important types of commitments but not really measurable and certainly not ones where you can bring real accountability to.  Now, with, with a lot of this data that has come out, however imperfect the data is, it leads to interesting conversations, right?  So, if you think about something, like, you know, employee satisfaction, you know, you can look at Glass Door, right?  However you feel about that set, whether you believe that, you know, it’s a place where disgruntled employees can negatively rate their company or post negative reviews, or whether you think that it is compelling and it is a, you know, something of a snapshot, it leads to a conversation with management that is rooted in something.  Right?  Where I can ask a real question about, why is it that you are rated this way versus your peers?  Or, why is it that the rating has been declining?  Or, what do you think about the relationship with your employees?  What are you doing to manage it or improve it?  And in, in, in many ways this is not anything new, right?  We’ve been looking at net promoters scores for, for a long time to gauge the relationship between, you know, companies in that space and, and their customers.  It’s just a new tool of accountability.  And so, being able to now validate these commitments that management is providing with some third-party assessment and have a more detailed conversation and start identifying real key performance in-indicators that management themselves can provide to us and talk about, it’s really made the conversation, just really, uh, much more enriching for both sides.

Charles Roth:    So, o-one last question on the position that ESG occupies at the idea generation level and, and with analysts themselves.

Jake Walko:       Yeah, and no other thing in the industry is as important as this concept.  And there used to be a tendency, if you think about the evolution of sustainability and the various sort of structures when in companies that, that have become ESG and sustainability, there’s a, you know, a, a long and, and very robust tradition of proxy voting as a dimension of these elements, especially of stewardship.  A, a history of, you know, these, these being compliance functions that turned into corporate governance functions that have turned into dimensions of ESG.  There’s a lot of history here and the way that this evolution has created a little bit of a disservice to how this analysis is, is conducted, is that it has created this aura that these things are done at the end of the day.  So, something like a, a check the box compliance exercise.  Or, run your portfolio through the screening, you know, at the end.  The reason why this is problematic is because if you think about the authentic application of sustainability considerations into the investment process, you want folks to be thinking about this actively throughout the process.  You want them to be selecting securities based on this.  You want them to be cutting out laggards as quickly as possible so that they can focus on the companies that are really the most compelling investment ideas.  We all know that, you know, you might start with a dozen companies to look at, but only one of them might get a full pitch, and even that company may not get a full investment.  So, if you are not integrating these factors at the very beginning, you’re not really doing it authentically.  What this means is, it is important to have folks who are well versed in ESG and are subject matter experts, know the data, can, you know, look to external sources and be well-informed about these things.  But it is equally important that the analysts themselves and the portfolio managers themselves think about these things at the outset.  It’s the only way that you’re really going to be looking at real, great investment ideas that are well‑positioned for a future that has sustainable dimensions and you’re avoiding companies that are problematic from the beginning.  If you don’t do that, you’re going to end up with, what I see as a lot of, sort of, post-fact justification.  I like this company.  It seems like a great investment.  I didn’t consider the ESG and now you’re telling me that it’s a laggard and we’re going to have an argument over whether it’s too much of a laggard to have a place in the portfolio.  That’s not really even as much as that has been the way that, you know, things that been done for a while, it’s not really a great way of doing this, uh, you know, going forward.

Charles Roth:    Not a true integration of the ESG process –

Jake Walko:       Right, not –

Charles Roth:    – are the true integration of ESG into the investment process.

Jake Walko:       E-exactly.  So, it’s important for folks to be educated.  It’s important those conversations to take place early on, however inconvenient it is.  It might be a 6:00 A.M., you know, conversation on a Monday.  It might be something that’s very time pressured, but that is much more important than having a conversation three weeks after investment that something screened and, you know, uh, i-i-in a way that, that makes it look unflattering.

Charles Roth:    Mmhmm.  It wasn’t, uh, window dressing after the fact.

Jake Walko:       Right, right.  Exactly.

Charles Roth:    So, thank you so much, Jake.  We, we appreciate your time.

Jake Walko:       Absolutely.

Charles Roth:    Today’s episode was produced and edited by Michael Nelson.  You can find us on Apple, Spotify, Google Podcasts, or your favorite audio provider, or by visiting Thornburg.com podcasts.  Subscribe, rate us, and leave a review.  Please join us next time on Away from the Noise.

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