Insights The Material Risk Indicator: A proprietary framework for assessing ESG risks and opportunities
February 25, 2021
February 25, 2021
The Material Risk Indicator: A proprietary framework for assessing ESG risks and opportunities
February 25, 2021
For over twenty-five years our unchanged investment philosophy for the global strategies we manage has been to own high-quality companies with the potential to successfully compound over the long term. These companies compound by steadily growing while sustaining their high returns on operating capital. As investors, we persistently look to identify material risks or opportunities to this compounding, including environmental, social and governance (ESG) factors.
We capture ESG risks and opportunities through our internally developed ESG scoring framework—the Material Risk Indicator (MRI)—a tool designed to record portfolio managers’ ESG company assessments in a consistent and comparable way over time.
The MRI helps to:
The fundamental question each portfolio manager (PM) must answer is whether the factors in question can significantly impair or enhance the company’s long-term returns on operating capital employed, our primary quality metric.
Source: Morgan Stanley Investment Management. The views and opinions expressed herein are those of the portfolio management team, are not representative of the Firm as a whole, and are subject to change at any time due to market or economic conditions. There is no assurance that a portfolio will achieve its investment objective or an investment strategy will work under all market conditions.
PMs are the ones who undertake the MRIs analysis as they best know the companies and industries. While we do use third-party ESG data for some of the inputs, this is a supplement to the analysis performed by the PMs.
The MRI is designed to better capture risks and opportunities for the companies we invest, which should further enhance our ability to manage downside risk as well as increase the potential for long-term compounding.
How it works
Each company is assigned a score from A through to E, with A being the highest score attainable. To determine this score, for each company, the relevant PM identifies and records the following:
In addition, for the company in question, the PM will:
How does the process impact portfolio construction?
The nature of ESG factors can make it challenging to quantify their impact. As such, we employ a range of methods to reflect the outcome of our ESG analysis in the portfolio:
It is important to note, however, that a high MRI grade does not automatically suggest a large position and a relatively low MRI grade does not automatically trigger a reduction or divestment of a holding. The ESG assessment is an important component of the research process, not the sole driver of investment decisions.
The strengths of our approach
When we assess stocks and make investment decisions, we debate their key merits and shortcomings as a team. We focus on those elements we believe are most impactful on the long-term sustainability of a company’s return on operating capital, and rigorously break them down, including ESG factors. We believe the introduction of the MRI in recent years has strengthened our approach. It adds further structure, reference and integrity to our long-standing investment process, which is designed to identify reasonably priced, well managed, high quality compounders with a strong or improving ESG profile, across the globe.