APRIL 23, 2021: ESG testing must go beyond the basics
By Bernard R. Horn, Jr., President and Portfolio Manager of Polaris Capital
As the global ESG “industry” grows, evidenced by a staggering $40.5 trillion in dedicated global assets (as of 2020), there is a rush to categorize, rank and measure companies’ ESG (environmental, social and governance) characteristics. A number of indices have sprung up to quantify ESG with Dow Jones, Morningstar, FTSE, Stoxx, MSCI and ISS joining the fray, each with their own objectives, definitions, methodologies and data. As is often the case, these rankings can be a blunt instrument, based on a simplistic exclusionary or “box-checking” approach; no two indices produce consistent results. For example, The Wall Street Journal in a September 2018 article entitled, “Is Tesla or Exxon More Sustainable? It Depends Whom You Ask” found that Tesla was considered among the best global car companies by MSCI, but the worst by FTSE on ESG issues.
ESG indices often rate companies on factors not pertinent to their industry. The impact of a bank’s carbon footprint is immaterial to global carbon emissions; yet some banks are directly involved in money laundering or lending to companies that have poor environmental, societal or governance records. ESG credited banks for the former and missed the latter, in part because the voluntary and reputation-focused nature of sustainability reports tends to leave out bad news.
Entry to ESG indices is seemingly subjective. Companies are bypassed, categorized in a “sin-bin” slot for mining, liquor, gambling or the like without consideration of their efforts to push their respective industries forward, and giving back to the communities in which they operate. Yet others, like British American Tobacco and Coca-Cola, are ranked in the top five environmentally and socially responsible companies on the FTSE 100.
And we witnessed ESG manipulated by crowd behavior, driven by the repurposed “S” in ESG: “social media” investing. This is not investing at all, and drives stock valuations to extreme levels. Case in point: as fellow portfolio manager Jason Crawshaw observed, the largest stock in the Russell 2000 is Plug Power, a hydrogen fuel cell story, with $25 billion market cap, 30 years in the industry, never made money, but is up 15x over the last year. There is massive speculation in “green” areas of the market, particularly smaller names where social media groups can “pump and dump”.
Companies like Plug Power actively position to become ESG entrants by changing their business model to fit the trend of the day with nary a thought to business sustainability five, 10, or 20 years down the road. We observe that once the stock meets predefined ESG thresholds, indices willingly slap on the ESG nomenclature, buzz is generated and investors’ cash starts flowing in.
Many of these stocks are now trading at elevated price-to-earnings multiples that are increasingly hard to justify. Those ESG ratings don’t take into account a company’s financial strength, how ESG fits into its competitive strategies or if ESG efforts deliver better shareholder returns. In fact, there is no conclusive evidence that socially responsible screens or company positions on lists such as the Dow Jones Sustainability Index deliver alpha for investors.
It may behoove investors (and indices) to steer away from narrowly-focused ESG rankings, and instead look at companies for their “shared value” properties. A theory propositioned by Porter et. al in a 2019 Institutional Investor article, “shared value” looks at the causal link between a company’s social impact and its competitive advantage. The thesis stands that tying the two together offers greater benefit to the public, and more often than not, shareholders as well. We support this notion, with slightly different rhetoric. At Polaris, we believe that sound companies with best practices and ethical underpinnings would prove sustainable over the long term – regardless of a label.
We do not rely on the blanket standards to inform our investment decisions. Instead, Polaris continues to conduct its own analysis to see if a company holds true to our high ESG principles. Dedicated personnel oversee this analysis, with Alexis Horn-Snyder, senior investment analyst and operations coordinator, continuing to spearhead weekly reviews.
As part of the process, we gauge ESG risks as they relate to company fundamentals; analyze market forces and companies’ ESG reporting; speak with management about relevant ESG topics; monitor ESG-related headlines on an ongoing basis; and engage on proxy proposals, such as remuneration standards tied to ESG and Board diversity. We are also keenly aware of who presents at corporate ESG presentations – is an ESG team showcased? We also look at a company’s history of ESG transgressions and how they were remediated while the future financial liabilities of repeat offenders are incorporated in our financial models. Our team asks the right questions; keying in on how ESG is sustainably intertwined with corporate strategy.
- Is the company addressing customer needs and anticipating the direction of the market?
Take Polaris portfolio company, BASF, for example. The German chemical company created ecovio, a biopolymer that is certified compostable – used today for waste bags, fruit and vegetable shopping bags, and even peanut bags sold at the Seattle Mariners’ baseball stadium. By engineering these bags to be compostable, it saves retailers the costs associated with recycling as well as helps the environment by cutting down on methane gas created by landfills. And eco-friendly solutions are gaining customer kudos.
- Does the company sustainably enhance productivity in the value chain?
Consider Polaris holding, Greencore Group, a leading manufacturer of convenience foods in the UK, which has a sustainability strategy for the entire supply chain – from sourcing, to manufacturing, to the customer: a deforestation-free supply chain by 2025; all raw materials sustainably sourced by 2030 and all surplus product donated to local communities by 2022. Greencore’s sustainability credentials are already well established. Since 2018, Greencore reduced its energy consumption by 10%, reduced its water usage by 9%, and cut its carbon emissions by 39%. In 2020 alone the Group donated over 1.5 million meals to people in need.
- Is the company investing to improve the business environment or industry cluster in which it operates? Is this outside the norm for competitors in the space?
BASF, SABIC and Linde (a Polaris holding) signed an agreement to develop the first electrically heated steam cracker furnace, using renewable electricity instead of fossil fuel gas for heating. This innovative approach for one of the petrochemical industry’s core processes may significantly reduce CO2 emissions within the chemical industry. Then there is Microsoft Corp., another Polaris holding, which pledged to go carbon negative by 2030, removing more carbon than it emits. And by 2050 it has vowed to erase the volume of carbon dioxide the company emitted since its founding in 1975. This raises the bar for corporate climate commitments, especially from rivals like Amazon.
- Does the company offer best-of-class employee incentives within the industry? Good employment practices lead to employee satisfaction, productivity and ultimately profitability.
Polaris holding, Intel Corp. offers a comprehensive employee program with: tuition reimbursement/education incentives; health/dental/vision insurance for employees and domestic partner/children; HSA accounts; retirement plan/401(k); health club membership; family planning services; eight weeks of paid parental leave; backup child care in emergency situations; life insurance and disability income protection. Additionally, employees are invested in the business, with eligible employees given the opportunity to purchase stock at a discounted rate. Workforce inclusion is also noted in its sustainability report, with the company having already met its 2020 goal, but striving to go beyond the industry standard with its 2030 goals.
Principles of transparency, good corporate governance, shareholder interest and positive community impact are generally associated with good management, employment practices, employee satisfaction, productivity and positive cash flow. These are qualities intrinsic to a company that may not “check the boxes” under the various industry ESG rating standards, but is a sustainable company by Polaris’ standards. In short, ESG and sustainability = good business = good return for shareholders.
Questions? Contact us at Client Service or use the Contact Us webpage to reach out. We are happy to speak with you about our ESG efforts or any other investing questions.
This blog was penned by Bernard R. Horn, Jr. in April 2021. Mr. Horn founded Polaris Capital (a leading Boston-based global and international value equity firm) in April 1995 to expand his existing client base dating to the early 1980s. Mr. Horn’s pure global value philosophy combines investment technology with traditional fundamental research. His 30+ year track record exceeds most current competitors in length and has produced admirable risk-adjusted returns since inception.
IMPORTANT INFORMATION: The views in this article were those of the author as of the article’s publication date and may be subject to change. Information, particularly facts and figures, are dated and/or may be outdated at the time you read this article. The funds managed by Polaris Capital Management, LLC contain securities of foreign issuers, including issuers located in countries with emerging capital markets. Investments in such securities entail certain risks not associated with investments in domestic securities, such as volatility of currency exchange rates, and in some cases, political and economic instability and relatively illiquid markets. Before investing, you should carefully consider a fund’s investment objectives, risks, charges and expenses. This article does not constitute investment advice, and should not be considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein.
