By Neil Brown, Justin Sloggett & Mike Tyrrell
For many years the direct integration of sustainability and corporate governance factors into investment valuation appeared to be a wholly desirable but stubbornly elusive goal. That was why the PRI drew a group of practitioners together to assess best practice in the industry and turned this into a guide which became the guide on Integrated analysis: How investors are addressing ESG factors in fundamental equity valuation.
Through a set of case studies structured according to the stages in a valuation process this demonstrated how these factors were being integrated into the valuation process in practice. It debunked the idea that RI analysts could do no more than identify vague concepts like ‘reputational risk’ by demonstrating that environmental and social factors can be priced in dollars, pounds and euros.
Eighteen months later, the document remains the most downloaded report ever for the PRI but this is perhaps unsurprising as integration (or identification of sustainability ‘alpha’) remains the hook that really engages ‘mainstream’ active investment analysts and managers in ESG.
Now, we need to expand beyond this initial report and identify more examples of integration in practice. Many analysts still require convincing that integrated analysis brings an information advantage and they need help adjusting their models to incorporate ESG factors. We also need to recognize that the initial report focused heavily on ‘sell-side’ research and there is a need to expose more of the evolution in ‘buy-side’ best practice.
This may not be easy. By definition, ‘integration’ is about capturing outperformance – which is the prime source of competition between asset managers and research providers – who tend to keep this good stuff for their paying clients. Also we have to recognize that sell-side research in some countries is under commercial threat which may make this source of ideas harder to access.
However, integration is so important to the overall health and development of responsible investment that we would like to share three more ideas on how the practice can be advanced:
• Open-source insights from ‘the Sustainable Valuation Value Chain’
• Highlight and share relevant research “#SustAlpha”
• Empower asset owners*Open-source the Sustainable Valuation Value Chain*
“Tell me and I forget, teach me and I may remember, involve me and I learn.” Benjamin Franklin.
On 7th October, the three of us will join the CFA Society of the Netherlands to bring sustainability to life within the valuation debate around the chemicals sector. Statements about the relationship between sustainability and corporate strategy from leading global chemicals companies will be challenged live on stage by sell-side and independent analysts (from KeplerCheuvreux) who will then, in turn, present their sustainability-driven investment recommendation to buy-side asset managers (ING Investment Management and Alliance Trust Investments). These asset managers will interrogate the sell-side’s valuation arguments and investment recommendations and then, in turn, present their own thoughts on how sustainability plays through the valuation of the stocks and the sector. Finally, asset owners will be invited to scrutinise the buy-side asset managers’ processes and justification for stock selection.
The audience will be involved throughout the process and encouraged to bring their own investment and valuation questions and thoughts to the process; the idea is to recreate, as closely as we are able, the investment debate that is happening across research floors around the world – and show how sustainability can be at the heart of it. If you’re in the Netherlands on 7th October, come and join us – and share the insights afterwards.
Events like this provide a great opportunity for different organisations with different perspectives on the investment process to come together to think about what might be next for integration. We intend to share the experience and the components of it so that it can be replicated around the world – wherever companies and investors meet to discuss sustainability and valuation. Keep an eye out for a follow-up article on what worked and what didn’t.
The fundamentals and best practices of integration can be simply disseminated in case studies. However, the practice of sharing cases is not yet widespread and a critical mass of case studies that prove that the practice is being applied in different sectors, in different markets and within different investment strategies in needed. That’s what social media is for!
So, if you have a piece of integrated research and/ or cases to share, please:
• Tweet it with #SustAlpha
• Share it with this newly set up LinkedIn group: Sustainable Alpha
• Tag it on SRI–CONNECT: SRI interests/Strgy – Sustainable Alpha
…or indeed share it with us and others in your value chain in the way that works best for you. We all understand the advantages of sharing best practice; but we are also all sensitive to the commercial and regulatory compliance requirements under which investment practitioners operate.
Empower asset owners
Of course, unless asset owners want integration and are empowered to demand it, everything that happens downstream will come to nothing. There are numerous ways that asset owners can assess managers’ integration efforts (Aligning Expectations: a PRI publication on this subject). Let us, however, contribute one more very simple technique for asset owners to use with their managers.1. Tell your managers that, at your next meeting, you would like to discuss, in relation to specific stocks in the portfolio, how sustainability and corporate governance factors have been factored into their target price / decision to hold the stock – allow them to choose three stocks to focus on
2. Tell your managers that you would like to repeat the exercise at your next meeting but that this time you, the asset owner, will choose the stocks yourself
3. Warn your manager that on the third occasion, you will choose the stocks yourself – but they will get no advance warning – this will require them to have an up-to-date understanding of the financial impact of the sustainability and corporate governance issues at all of the companies that they hold…
Of course, there will be stocks in any portfolio where the sustainability or corporate governance factors are not sufficiently material to merit integration. But that’s OK; these won’t take long to discuss. The point is to ensure that owner and manager share an awareness and understanding of where sustainability and corporate governance factors give rise to risks and opportunities and where they don’t. And, of course, to ensure that appropriate action is taken as a result.
Neil Brown is SRI Fund Manager at Alliance Trust Investments, Justin Sloggett is Senior Manager, Listed Assets at the PRI and Mike Tyrrell is Editor of SRI–CONNECT.