18 Sep 2019
Company stewardship is something many investors have focused on and which often turns out to be a successful long-term strategy, as businesses managed from the perspective of a long-term owner will often prove to be amongst the best for external or minority shareholders over the longer-term. Many investors who look at strong stewardship in a business also pay attention to sustainability issues. This approach is quite different from an ethical fund in that general companies are not screened out, but looked at on an individual, qualitative basis. However, certain types of businesses are avoided where they are considered to be harmful to society, with tobacco and armaments as obvious examples. Looking at stewardship and sustainability issues is a further way of highlighting stocks which meet the definition of high quality, which again has often been an excellent way for people to invest.
The world today is very different from 20 years ago and companies are expected to integrate environmental, social and governance considerations (ESG) into their business strategies. Whilst fund managers have always looked for companies that have strong management teams and sound long-term growth prospects, investors have now come to realise that part of this is dependent on businesses not suffering sustainability headwinds. On top of the normal ESG guidelines and considerations, sustainability investment takes investors one step further by focusing on long-term sustainability themes and companies that are well positioned to benefit from, and contribute to, the sustainable development of the societies/countries in which they operate.
When looking at sustainability issues, another important factor is to ensure that there are no potential negative externalities which could hit a business. This could be long-term environmental liabilities or possible litigation against tobacco companies. Tobacco is a great example of a sector that has provided strong, stable returns for many years, despite the fact that it was known to be providing a product harmful to society. Vaping has clearly hit tobacco companies hard and there are other concerns. More prosperous and better educated societies typically smoke less and countries providing free or subsidised healthcare are likely to want to recoup the cost of treating tobacco related illnesses from the companies themselves.
Engagement is also typically an important part of sustainability investing. Positive engagement on ESG issues can be a powerful tool in driving shareholder value and protecting and enhancing returns.
Companies acting in a non-sustainable manner will at some stage hit a major problem which can lead to severe consequences for their share price. In the UK so-called payday lenders charging very high rates of interest have recently suffered from a regulatory crackdown with very serious consequences for their shareholders. Another example of where society has driven regulatory change has been the severe restrictions on the stakes to play fixed odds betting terminals which have hit the share prices of the betting shop businesses hard. Companies specialising in spread betting or providing CFD investment accounts, where retail investors have been able to leverage their original stake, have also seen severe restrictions on their ability to do business, with extremely negative effects on the share price.
Companies can be classified through a sustainable development lens. The first is sustainable goods and services. These are companies that have a positive impact on society, the environment or on health. Typically, these will be well positioned for shifting consumer preferences and not exposed to potential regulatory headwinds or long-tail liabilities. Examples of this include Natura a Brazilian cosmetics business and Standard Foods in Taiwan.
The second is responsible finance companies with a purpose that have a license to operate and are risk aware. These companies are the opposite to investment banks. The CEO of Handelsbanken in Sweden describes their purpose as a support function of the actual real economy. Other names include Kotak Mahindra and HDFC in India and Banco Bradesco in Brazil.
The third category is required infrastructure, necessary to support long-term sustainable development. There is a focus on environmental efficiency, operational performance and license to operate. Examples of this include Wartsila in Finland, a major beneficiary of the legislation requiring much lower sulphur pollution from shipping fuel, and Pidilite in India.
BRAC Bank is Bangladesh’s leading financial institution and focuses on SMEs. This company is a great example of how micro finance and SME lending can be a sustainable business, with the company not following the typical western pattern of charging high interest rates in the expectation of high defaults. BRAC Bank itself is 18 years old and was started to finance the world’s largest NGO, which has an annual development budget of $1bn. Despite, or because of, a focus on low cost SME banking, it has an ROE close to 20% and return on assets of 1.8x with capital adequacy of 14%. Whilst other banks in Bangladesh charge 25-30% interest rates on SME loans, BRAC Bank charges 15%, believing that the higher rates are wrong and unnecessary. Interestingly, non-performing loans to the smallest customers are the least significant part of the business. This bank applies social criteria when lending and thinks about ethics. The bank will not do business with people, companies or products that harm society or people. It doesn't work with the tobacco sector, which is substantial in Bangladesh. Neither does it finance the ship-breaking industry, which has attracted a lot of criticism due to its unsafe labour practices and high fatality rates.
BRAC bank has a focus on sustainability and environmental sustainability and engages in what the Managing Director describes as “people before profit banking”. This spotlight on sustainable lending has resulted in low levels of non-performing loans as large corporates that can use political influence to defer paying back loans from banks are avoided as customers. The bank has also launched a specific women’s product, which is lower cost and offers a deposit option, helping to improve women’s place in society. The focus on sustainable investing has not come at the cost of lower returns and the BRAC bank has been an excellent performer for many years.
Whilst many investment houses pay lip service to ESG considerations, for the job to be done properly it involves serious, corporate engagement and much more than box ticking. The approach can, certainly looking at historic returns, deliver outcomes with lower volatility and better downside protection, especially in difficult markets, as well as improving corporate behaviour. Investing with a sustainability lens enhances rather than detracts from shareholder returns in that large blow-ups that result in permanent destruction of capital, can be avoided. Some very high-profile fund managers, who have ignored sustainability issues, have seen this come back to bite them with significant hits being delivered to investors in a short space of time. Sustainability investing has already become mainstream today and the favourable tailwinds enjoyed by companies expanding in a sustainable manner is likely to only increase future investor interest in the subject.
Graham O'Neill, Senior Investment Consultant, RSMR
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