Global Equity Observer
Seeking Sustainability: Compounding and ESG
 
 

Global Equity Observer

Seeking Sustainability: Compounding and ESG

 

The International Equity Team spent 2017 ensuring that environmental, social and governance (ESG) analysis was fully integrated into the investment process across all its strategies. This did not require any radical changes given the team’s philosophy of investing for the long term and always being mindful of risks to companies’ returns, but it did involve formalising the process around ESG risks and opportunities and, in particular, environmental and social factors.

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ESG [is] fully integrated into the investment process across all strategies
 

Governance has always been a focus of the team, as weak governance has always been a threat to compounding. Our global portfolios are focused on very high-quality companies that generate plenty of free cash flow and give management plenty of degrees of freedom. They are at risk if there is insufficient investment to maintain the franchises, effectively milking the businesses, or if the free cash flow is squandered on low-return acquisitions.

The importance of the environmental and social lenses is rising. The future of carbon in the world economy is unclear, leaving the risk of trapped assets, be they oil in the ground or combustion engine production lines in an auto factory. Given the shape of the portfolio, with minimal exposure to carbon, the larger threat is in the social area. This is not only the increasing volatility of politics – and the more robust regulation which accompanies it – but also the rise of social media, which means brands that have been built up over decades or centuries can be tarnished almost instantly. Given these threats, an ESG focus has become essential for long-term compounding.

Thinking robustly about ESG can therefore reduce risks, but it can also point to opportunities. This may be L’Oréal’s focus on natural ingredients, giving it a competitive advantage with consumers, or the development of FlyKnit and FlyLeather by Nike, dramatically reducing waste and improving gross margins.  Staying relevant to the consumer can bring market share gains. In addition, superior governance can drive gains, as in Accenture’s enthusiastic adoption of the ‘New,’ helping companies with their digital transitions, which is now bearing fruit after several years of squeezing margin improvement. The partnership culture at Accenture meant that the company focused on the long-term opportunities rather than the short-term earnings.

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Our portfolios score well on independent ESG scores
 

The team’s ESG approach, like the rest of its investment process, is bottom-up and at the company level, focusing on material risks and opportunities that can affect the future returns of the companies in the portfolio. It includes access to the third-party ESG research and controversy reports from MSCI and Sustainalytics, which contribute to identifying and assessing the key ESG concerns that could undermine the long-term sustainability of a company’s returns. This element is more useful than the actual ESG scores, which the team takes with a pinch of salt. That said, our portfolios score well relative to the benchmark on independent ESG scores. Equally, the engagement with corporates, including proxy voting, is undertaken by the team, with support from Morgan Stanley Investment Management’s (MSIM) Global Stewardship Team.

The basis of the ESG analysis is to support returns, and thus compounding, rather than any moral stance. However, the team has recently launched the Global Sustain Strategy. This is based on the existing Global Quality Portfolio but offers a choice to investors by excluding several controversial sectors, notably tobacco, alcohol, weapons, gambling and fossil fuels.

 
Head of International Equity Team
 
 
Managing Director
 
 
Executive Director
 
 

RISK CONSIDERATIONS
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy's assets were invested in a wider variety of companies. In general, equity securities' values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. Option writing strategy. Writing call options involves the risk that the Portfolio may be required to sell the underlying security or instrument (or settle in cash an amount of equal value) at a disadvantageous price or below the market price of such underlying security or instrument, at the time the option is exercised. As the writer of a call option, the Portfolio forgoes, during the option's life, the opportunity to profit from increases in the market value of the underlying security or instrument covering the option above the sum of the premium and the exercise price, but retains the risk of loss should the price of the underlying security or instrument decline. Additionally, the Portfolio's call option writing strategy may not fully protect it against declines in the value of the market. There are special risks associated with uncovered option writing which expose the Portfolio to potentially significant loss.

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