Beyond ESG Scores: Active, Governance-Driven Alpha

Beyond ESG Scores: Active, Governance-Driven Alpha

ESG Investing as an Active Financial Tool

Charles Roth: I’m Charles Roth, portfolio specialist at Thornburg Investment Management. I’m here today with Brian Burrell, portfolio manager with a particular focus on ESG. Brian, can you address how you view ESG and what differences there are to conventional ESG screens, and how you view ESG as not just as a values-centric theme or factor?

Brian Burrell: Yes, the distinction between value as in financial and values as in some kind of ethical delineation, I think is important. So ESG, simply put, is a tool in the investing toolkit to generate better financial value. There aren’t any moral judgments. It’s merely a way to look at companies and investing through a different lens. Broaden that toolkit and find where ESG analysis can come to bear on financial returns.

And I think it’s an exciting time for ESG investing. The amount of information and data that analysts can use to find good companies and generate superior returns is very broad. So, think about Benjamin Graham back in the 1930s. He came up with a novel idea of using price to price-to-book ratio to analyze stocks, wrote a whole book about it called Security Analysis. Fast forward to today. Smart beta products are all over the place and most of them are computer or computer trading. They’re algorithmic. They use price to book, and it’s become commoditized. However, when thinking about ESG investing tools such as Glassdoor.com, where employees review their employers, or looking at things like emissions a manufacturer generates as a window into its efficiency are all tools that we have at our axis to pick good companies.

So essentially, Charlie, what we’re looking at is, looking for material, i.e., financially meaningful and integrating those factors of analysis amongst our team to pick better stocks.

Charles Roth: What do you use as a benchmark if the focus is on delivering risk adjusted returns? Is that the main reason why you prefer to benchmark against traditional and not ESG specific benchmarks?

Brian Burrell: Yes, that’s the idea. The ESG analysis is a tool in the toolkit to outperform standard benchmarks. There’s no ESG benchmark that I think is really relevant when just looking to add, performance through the ESG analysis that that we’re doing here. It’s simply using those points of analysis which perhaps are underappreciated in the general financial management community in order to pick better stocks and generate a better portfolio over time.

Charles Roth: Can you, address the potential issues with the way typical ESG benchmarks are constructed?

Brian Burrell: Sure. I think they’re quite problematic, actually. And if you look at the third-party data providers scoring systems using ESG metrics, they often don’t agree with each other. And I think one of the reasons that’s the case is that, well, ESG disclosure isn’t really standard. And when you broaden out to global investing, it’s especially, divergent between various countries.

So, any index which is trying to score and break all of the important ESG analysis into a single score or number, I think will inherently be flawed. So we choose to look at the, ESG metrics, ourselves. We choose to incorporate them into our integrated, financial analysis. Rather than rely on any third party, data scoring, methodology. And this helps to give a more holistic, view into the company’s value in their long-term sustainability rather than a single score that misses the mark.

Charles Roth:  So I suppose on both a qualitative as well as a quantitative financial valuation basis.

Brian Burrell: Yeah. That’s right. You know, you can look at various, quantitative scores in the environmental realm. For example, you can look at, waste or water that is used in a manufacturing process and normalize that to a level of profitability. The degree to which ESG is integrated into the company’s strategy is often a key indicator for how the company is able to attract, retain and incentivize talent.

Charles Roth: Yet it’s interesting because it seems that there has been a tremendous amount of passive international ETFs and index funds tracking ESG focused benchmarks. They’ve seen remarkable growth in recent years. Adoption rates and inflows into passive, sustainable investing strategies have been particularly strong in Europe, where, as I understand it, more than half of all new ETF investments over the last few years were ESG-focused. And globally, assets under management and ESG ETFs have hit record levels. So obviously there’s a draw with the passive strategies, but I’d kind of like to address some of the challenges with these passive strategies. Could you address perhaps their limited flexibility? Are they dormant strategies or are they nimble in their rebalancing? How do you view the flexibility and the consistency with which they incorporate ESG highly scored companies?

Brian Burrell: Yeah, that’s a great question. The inherent flaw is that these scoring systems are very much backward looking. So, I grew up in Wisconsin playing hockey, and Wayne Gretzky taught us skate to where the puck is going. And if you look at a company’s sustainability profile, it’s constantly evolving. Now these scoring systems will look at the past and how they’ve performed, you know, in the past many years.

Whereas what we actually care about is the trajectory of these sustainability metrics and how they come to bear on the company’s financials. So, number one, passive is backward looking. Number two, if you actually break apart these, ESG indices or ETFs that are run passively, you find that inherently they’re somewhat closet benchmarking tools, meaning that they hold lots, lots of companies look very similar to the benchmark and end up with quite strange, portfolio holdings. You have to ask yourself, if you’re investing in an ESG index, whether or not you really want the key question to be, do I want the more sustainable tobacco company or the less sustainable tobacco company? I think it loses the big picture in the way they construct these, these indices.

Whereas if you’re actually asking the key questions of how does sustainability impact the financial profile, you’ll be led to companies which have a longer term, outlook, to the way that they’re running business and often avoid some of the risks inherent in these indices.

Charles Roth: I suppose if there are ESG leaders that perhaps under new management are stumbling and you happen to notice that, they’re starting to lag uncertainty as to metrics, as an active manager, you can actually reduce or exit those positions much faster than an index rebalancing that happens on a semiannual or annual basis.

Brian Burrell: I think that’s right, that the trajectory of a company’s earnings are the ultimate determinant in stock prices. So those are, situations where you have, say, governance improve, improving capital allocation, improving and higher returns on invested capital or earnings power. You get the double whammy with an ESG momentum stack, where they not only increase the financial, fundamentals, but they also tend to receive a higher multiple in the market. And that can be quite powerful for financial returns.

Charles Roth: I suppose then it would beg the question of ESG greenwashing. So companies that optically engage in ESG, but if they’re not really pursuing it at, an integral level in their operations, it’s not going to be reflected in their margins and ultimately their earnings.

Brian Burrell: I think that’s right. The devil’s always in the detail. And with these ESG metrics, if they’re being managed to rather than incorporated as part of a broader financial strategy, they often lead to waste within corporations. What, what is interesting is when companies realize that, say, hey, policies on sustainability are often, identifiers with a brand, and that can increase brand loyalty and hence profit margins.

Those are the situations where there is a clear linkage between the ESG metrics and the financial metrics. So it’s quite important to be active and to understand from top level management through engagement how they are incorporating those strategies or whether it’s a check the box, exercise for them.

Charles Roth: And almost by definition, passive ESG vehicles can’t engage with company management directly.

Brian Burrell: I think it’s one of the most telling situations you can put yourself in is to interview a company’s CEO and say, how do you integrate ESG into your strategy to benefit the bottom line? Sometimes in those meetings, the CEO has a great answer. He thought he or she thought hard about this in other situations that same CEO may turn to the IR next to them and say, oh, that’s an ESG question, “I don’t deal with that. Can you answer for me?” And those are the kinds of engagements and that active management that I think is where you actually find that clear linkage between financial returns and ESG in the companies you invest in.

Charles Roth: Well, it’s very interesting on that point of a CEO who’s a woman. Obviously, there will be a variety or a range of ESG metrics region to region. So, in some regions you might have, ESG metrics that that are very different versus the same metrics in other regions, and they’re probably very hard to account for and passive indices, whereas you probably do it very actively in your sort of competitive analysis between companies in different regions.

Brian Burrell: Diversity means very different things, say, in Japan, I make an annual trip there, and diversity there often means how global is your management team? Do you have non-Japanese representatives to run businesses that are operating global and hence understand those various economies you’re operating in? If you go to, say, northern Europe, it’s much more of a gender, type of diversity. And so these types of things aren’t necessarily captured in the standard indices and ETFs that are run off them. What we want to understand is where the rubber meets the road. Where do these diversity policies actually generate financial value. And I think having that global approach and understanding the differences in the way that these economies and companies operate is important to finding those value generating companies.

Charles Roth: Brian, I want to circle back and drill down a little deeper into how exactly you use E and S and G as straight financial, qualitative and quantitative metrics in your analysis. So what does the E mean to you? And what does the S and the G mean to you?

Brian Burrell: We ask very simple questions for E, S and G aimed at linking those metrics to financial value. For example, with E, the simple question of does the company efficiently utilize resources? This can be a window into their ability to turn, the inputs into the output of the product that they’re manufacturing. Doing it more efficiently leads to better margins.

With S, the simple question is, does the company attract, retain, and incentivize talent to become a well-functioning organization that has superior productivity measures with G. The simple question is, is management aligned with minority shareholders? Does that compensation package that ultimately incentivizes management in how they behave? Does it align with what we want as shareholders? So ESG can mean a lot of things to a lot of different people. But when you boil it down to these simple questions focused on value generation and not values, I think it levels the playing field to find better stocks and construct a better portfolio.

Charles Roth: I would imagine with the G that it also involves qualitative analysis of management’s execution. Do they execute well? Do they identify resource allocation effectively and then, pursue it. And so, you mentioned Japan. There’s a consumer electronics company multinational, that is one of the more interesting ESG stories that you’ve pursued over the years. Would you be able to apply how you approached your analysis with this company, and how you ultimately determined whether there was the potential for higher ROIC and better margins down the road with what the management was doing?

Brian Burrell: A lot of companies in Japan essentially operate as employment agencies. They do things because it employs people and because they have done things. But every once in a while, you get a company that takes a fresh look at capital allocation and says, we want to focus on what we’re good at and get rid of all the stuff that’s not working.

So this consumer electronics company you mentioned has been on a ten year journey of disposing of, high, asset intensity businesses where the returns on capital were low. Refocusing capital towards the higher profitability and higher growth businesses and has returned, to growth in its core, entertainment businesses. Now we see a higher return on capital for the company as a whole and a better multiple in the market. That double whammy of higher earnings and a higher multiple. And it all started with governance reform where capital allocation was front and center.

Charles Roth: I want to from there just expand generally to international markets. Do you see them as less efficient than, U.S. markets? I’m sure it varies country to country, region to region, particularly in emerging markets. But how would that generally then lend itself to active investing and in particular a generalist model versus a specialist model of investing?

Brian Burrell: I think it goes back to those differences that we see across various geographies and how companies operate, and what these various ESG metrics that we look at mean. So, I’m not going to compare the same metrics for, say, a Japanese company to those in an emerging market. I’m going to identify the ESG metrics that are meaningful for that company in its own particular circumstances. And I think this kind of perspective in the ability to analyze what it is that actually drives returns is something that sets apart a company that is able to kind of take that perspective, you know, see the forest for the trees, you know, as an example here. ESG data is not standardized, so it requires an active manager to start digging into the details. What level of disclosure does this company have? Now if you look at audited financial statements, they’re signed off on by an auditor. And they’re generally given reasonable assurance as to their correctness. But if you start digging into the details of sustainability disclosures, they’re often signed off on by the auditor and a lower level of assurance, limited assurance.

And these distinctions matter in both what the company is disclosing, how they’re disclosing it, and the degree to which you can rely upon this to make decisions. So, I think it’s really important to understand those particulars for each company that you’re looking at.

Charles Roth: Okay. Well, thank you so much, Brian.

Brian Burrell: Thank you.

Important Information

The views expressed are subject to change and do not necessarily reflect the views of Thornburg Investment Management, Inc. This document is for informational purposes only and does not constitute a recommendation or investment advice and is not intended to predict the performance of any investment or market. It should not be construed as advice as to the investing in or the buying or selling of securities, or as an activity in furtherance of a trade in securities.

This is not a solicitation or offer for any product or service or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by Thornburg or its affiliates. Nor is it a complete analysis of every material fact concerning any market, industry, or investment. Data has been obtained from sources considered reliable, but Thornburg makes no representations as to the completeness or accuracy of such information and has no obligation to provide updates or changes. Thornburg does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. The views expressed herein may change at any time after the date of this publication. There is no guarantee that any projection, forecast or opinion in this material will be realized.

Investments carry risks, including possible loss of principal.