by Raine Naude

A nuanced approach

ESG is the key to responsible investing


Responsible investing has become a front-page issue in the last year as companies, investors and asset managers have had to respond to ethical and governance lapses that have made the news. A few broad approaches to responsible investing have developed over time. At Allan Gray we use two of these strategies – Environmental, Social and Governance (ESG) integration and shareholder engagement – to ensure that we are responsible stewards of our clients’ capital.

Screening: not black and white

Investment managers sometimes offer funds that screen out or exclude certain shares or include others. For example, Social Responsible Investment (SRI) funds use negative screening to exclude companies or sectors based on ESG and ethical criteria. Common historical exclusions from these SRI funds include “sin” stocks such as tobacco, alcohol, gambling and weapons. Increasingly, companies that produce or use large amounts of fossil fuel are excluded due to their environmental impact.

Depending on the lens applied by the company, the same ESG principles are often applied esoterically, giving different exclusion or inclusion lists. For example, Parnassus Investments and Domini Impact Investments are two US companies specialising in responsible investing. The Parnassus Core Equity Fund, one of the largest SRI funds in the US, historically has excluded Coca-Cola because it sells unhealthy products. On the other hand, Domini’s Impact Equity Fund invests in Coca-Cola as it met its “investment impact standards” through strong charity initiatives and activities in the development of minorities and communities.

Most companies have both positive and negative impacts on the environment and/or society. These can be complex to weigh up: what happens if a company has a positive social impact, but is damaging to the environment? Different social and environmental concerns also resonate with different people. A survey of a diverse group of people will be likely to draw a broad range of companies and sectors and plenty of disagreement on what is excluded. We have a responsibility to act in the best interests of all clients, which makes maintaining a universally acceptable exclusion list difficult – especially within the confines of the Johannesburg Stock Exchange (JSE).

While we do not generally apply screening as a mechanism, our only screening exception is the chief investment officer (CIO) veto. This may be used to prohibit investments in a company that the CIO deems unethical in nature. The CIO is accountable to the Allan Gray board for his decision to veto a share (or not).

Sustainability themed and impact investing

Sustainability-themed investment targets companies along the themes of environmental sustainability and sustainable development. There is not a broad enough choice on the JSE to make this a practical approach for Allan Gray. Similarly, impact investing targets investments that generate a positive environmental and/or social impact alongside a financial return. Importantly, the benefits must be measurable and reported with investment returns. This approach lends itself to private equity investments in unlisted companies and small and medium-sized enterprises (SMEs), which are outside our investment universe.

ESG integration

The most common approach to responsible investing is ESG integration, which the United Nations Principles for Responsible Investment (UN PRI) defines as “an approach to investing that aims to incorporate ESG factors into investment decisions, to better manage risk and generate sustainable long-term returns”.

Allan Gray follows this approach and we are a signatory of the UN PRI. Material ESG factors are incorporated into our investment research and are robustly debated in our internal policy group meetings, in which we discuss the investment case for shares or bonds to be included or excluded from our portfolios. Many of these issues are dynamic and we continually monitor ESG risks throughout the life of an investment. We do not have a standardised ESG risk-rating system, instead evaluating each investment on a case-by-case basis using fundamental research to avoid “box-ticking”.

Shareholder activism

Shareholder activism is the approach you will hear of most in the press. It includes filing shareholder proposals, proxy voting at company Annual General Meetings (AGMs) and directly engaging with executives and board members on ESG matters to influence a company’s behaviour. There has been a pronounced global increase in shareholder activism on governance issues over the past decade. More recently, the number of environmental and social shareholder resolutions being proposed and supported at AGMs is growing.

Shareholder activism is a key component of our responsible investing strategy and we have been successful in influencing a number of positive changes in companies in which we invest. We publish our proxy voting record quarterly on our website and report on our ESG engagements in our annual Stewardship Report.

We believe that financial performance is often linked to managing ESG risks in a sustainable manner, so it makes sense to invest in companies with a strong ESG focus. However, investing at the right share price is critical. A brilliantly managed company can be a poor investment if you pay too much.

Our investment philosophy is to select stocks that we believe are undervalued by the market and will offer capital growth as their value is realised. A company that is putting effort into maintaining its social licence to operate, while behaving ethically and in an environmentally sustainable way, is more likely to produce sustainable free cash flow and financial returns over the long term. A company that does not manage its ESG risks appropriately will erode its ability to generate sustainable free cash flow over the long term. In practice, the impact of ESG factors on a company’s intrinsic value is usually dynamic and requires diligent analysis.

Investors should select an investment manager or fund where the responsible investing strategy best aligns with their needs and values. In our opinion, ESG integration is the most pragmatic way to balance financial returns with ESG considerations. In addition, by actively managing your fund and engaging with the companies in which we invest, we contribute both to safeguarding your investments and to helping your investments have a net positive effect on society.

Raine Naude, ESG Analyst, Allan Gray

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Issue 72