How to Select Sustainable Compounders

Sustainable Investing

How to Select Sustainable Compounders

March 19, 2021

Very few companies make the grade to be included in the Global Sustain portfolio, in our view, one of the highest-quality ESG-integrated portfolios available to investors. We only invest in businesses we believe can generate high, sustainable future returns on operating capital. These high-quality companies are extraordinarily rare.

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The resulting Global Sustain portfolio compares favorably to ESG peers in terms of two key quality metrics: margin stability and returns on operating capital

Quality: It’s all about sustainability of returns
We explicitly exclude capital-intensive, low-return companies because they are unable to sustain high returns on operating capital. Energy and materials companies, for example, are too cyclical to meet our requirements. Even utilities, which are less cyclical, fail to generate sufficient returns on capital due to their massive amounts of capital and equipment.

Instead, we target high-return on capital, non-cyclical companies with pricing power. Many are found in the technology, health care and consumer-oriented sectors, which tend to pollute less. We believe Global Sustain is, therefore, an inherently low-carbon portfolio. Its carbon footprint is less than 30% of the MSCI World Index (left chart).

Carbon intensity scores, however, do not drive our security selection. We first screen the universe for high-quality companies with attractive valuations. As part of our fundamental research and engagement with companies, we consider – on a case-by-case basis, where appropriate – material environmental or social or governance issues that have the potential to either enhance or disrupt a company’s sustainability of returns. These issues include energy sources for data centers, the sustainability of supply chains, packaging for fast-moving consumer goods companies, consumer relevance, data privacy/security and product quality.

A portfolio that avoids controversial sectors
Global Sustain is tobacco-free, alcohol-free and free of fossil fuels. The most capital-intensive sectors – commodities, fossil fuels, utilities and weapons – are naturally excluded because they are too cyclical to meet our criteria. The resulting Global Sustain portfolio compares favorably to ESG peers in terms of two key quality metrics: margin stability and returns on operating capital (right chart).

¹ Source: Factset, MSCI ESG, Morgan Stanley Investment Management; as of December 31, 2020. Updated annually.

² MSCI ESG Research defines a portfolio’s carbon footprint as the carbon emissions (Scope 1 and 2) of a portfolio per million dollars invested. They sum up all the emissions in a portfolio based on the investor’s ownership share, using reported or estimated emissions data. ROOCE (Return on Operating Capital Employed) = EBITA (Earnings Before Interest, Taxes and Amortization) / PPE (Property, Plant, Equipment) + Trade working capital (excludes goodwill) last twelve months (LTM), Ex-Financials. EBIT Margin Stability is (1-(std deviation)/mean)) 10 year average. Free cash flow yield is a financial ratio that measures a company’s operating free cash flow minus its capital expenditures per share and dividing by its price per share. Free cash flow yield ratio is calculated by using the underlying securities of the fund. Data as of December 31, 2020. Updated annually.

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. ESG strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance.Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. 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-capitalisation 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.

Vladimir Demine

Head of ESG Research

International Equity Team

INSIGHTS

Sustainable
Signals Survey

7 key findings emerged when we asked asset owners about their views on sustainable investing.

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