ESG: Separating truth from fiction in the hunt for sustainable dividends
Quakers and Methodists in the 19th century were the first to encourage their followers to choose ethical investments as part of their faith.
But it wasn’t till a hundred years later, in the 1990s, that the idea – that companies should behave responsibly in the pursuit of profit – began to take hold in the wider world.
The Bhopal disaster in India, which saw more than 500,000 people affected by a poisonous gas leak at a chemical plant owned by an American multi-national was a wake-up call for the corporate world.
That decade also saw the historic Rio Earth summit, focusing attention on how human behaviour threatens the planet, and investors pulling out of South Africa in protest at the apartheid policies of the government. More recently, the use of Third World child labour to make cheap clothes and shoes has forced companies to look hard at themselves and how they do business.
Thus, the seeds of Environmental, Social and Governance (ESG) criteria were born. A new generation now questions how business is done and the impact it has on people and the environment.
In 2011 just one-in-five S&P 500 companies reported on ESG. Today that figure is 80 per cent, according to research firm Axioma. ESG has moved from the fringes to the mainstream.
But while financial reporting has clearly defined metrics, how do you measure a concept like social responsibility?
How do you know if a company is genuine about its commitment to the environment?
Companies often ‘talk the talk’ but how do you know if they’re ‘walking the walk’?
And above all else how do you build this into a successful equity investment strategy that seeks out consistent, long-term dividends?
For us at Kempen the two keywords are engagement and transparency. We built our reputation on actively managing our investments. That means we engage regularly with the companies we invest in. By engaging, talking and sharing information we can properly understand if ESG criteria are been actively pursued or are nothing more than a ‘box-ticking’ exercise.
Kempen bases its criteria for responsible investment on the international conventions such as the United Nations Global Compact (UNGC) and the Principles for Responsible Investment (PRI). In combination with the Guiding Principles on Business and Human Rights, these two frameworks build the foundation of Kempen’s ‘Convention Library’.
These cover areas such as human rights, labour rights, governance, environment, corruption, controversial weapons and so on.
Our approach within a clear framework; first we exclude, then we integrate and finally we engage. And above all else we demand transparency. Not only from our investment targets, but also in the way we report on ESG as part of the overall decision-making process.
So, in the exclusion phase we don’t invest in tobacco or controversial weapons, such as cluster bombs. We avoid companies that are involved in an issue fundamentally contrary to KCM ESG criteria.
The integration phase means we are transparent about the different factors that go into our decision, including ESG. So, we break down our EPV model into its constituent parts – cash flow and assets, brand/franchise value, growth value and the ESG value. This way our clients can see exactly how we arrived at our decision.
And finally, there’s the engagement phase. We believe that by being active we can fully understand how responsible an organisation is being, or how willing they are to change their strategies to meet the demands of the modern investment environment.
In 2018, for example, we took part in more than 200 company meetings and conference calls and held companies to account on their performance by asking relevant questions and demanding transparency.
All this is underpinned by the principles of our investment strategy. We buy below intrinsic business value with a margin of safety to reduce risk and assess over the cycle earnings to determine valuation.
We keep a close eye on capital allocation and prefer restrained investment that leads to overall higher returns.
But above all else it’s about looking to the future. Since for us it’s about long-term investments, of more than five years, sustainable dividends are fundamental to what we do.
It might be tempting to chase fast growing companies for short-term gains, but in the current investment environment, ESG is becoming a crucial factor and understanding how this may impact the long-term growth plays a big part in how we do business.