Feb 12, 2020
It is always surprising how quickly attitudes change. When I was at university, cigarette companies produced sexy advertisements showing beautiful people skiing or sailing while smoking. Fast forward to 2020, and people smoking on the street are now frowned upon.
In 2008, environmental, social and governance (ESG) issues were seen by many in financial markets as at best, a good marketing angle or at worst, a waste of time. Twelve years later, and conditions have shifted dramatically.
The first phase of integration involved screening out prohibited stocks or sectors. Certain stocks or sectors (for example, arms manufacturers) were excluded from investment mandates. Over the last few years, asset owners globally have progressed in this area. Most recently, we have seen the rise of a number of large asset owners excluding coal from their mandates – or limiting the proportion of total revenues that can come from coal for companies in which they invest. The result is that companies like Anglo-American are looking to divest from their coal assets.
Phase two evolved over several years but has resulted in the integration of ESG considerations into the investment process. Analysts and portfolio managers have long recognised the value of including assessments of non-accounting information like business strategy and competitive strengths into their company analysis. In the last decade, and particularly in the last five years, they began to also include assessments of ‘softer’ areas like labour practices, environmental practices and governance.
The impact of concerns in areas such as these is now included in either cash flow projections or discount rates, which affect company valuations. This makes sense – as these soft issues can have a hard financial impact.
A good example is the mining industry, where a poor safety record can result in accidents and stoppages, thus dramatically impacting cash flows. Sibanye Gold experienced a number of safety incidents in early 2018, which led to 23 miners tragically passing away. Investec Asset Management was a significant shareholder of the company at the time, and we engaged repeatedly with company management. The business performed a deep overhaul of its approach to safety – resulting in a material improvement in mine safety in the period since. There have also been far fewer work stoppages, thus improving the productivity and profitability of its operations.
In South Africa, the integration of ESG assessments into financial metrics has been heightened by recent governance failures, most notably Steinhoff. While it is always difficult for public market investors to detect fraud, we have tried to better identify the warning signals – for example, low earnings to cash flow conversion rates. In addition, asset owners are increasingly requiring asset managers to have integrated ESG processes that deal better with ESG concerns. At times, these requirements extend to unexpected mandates, like global debt.
The third phase of evolution has been the increasing sophistication of the engagement process. In 2011, Investec Asset Management formed the Investment Governance Committee, which is chaired by one of the Co-CIOs. Initially, this committee dealt with proxy voting and the engagement around that. However, the emphasis has increasingly shifted from reactively focusing on proxy voting, to a proactive engagement on critical issues that a company faces.
In South Africa this is particularly important as Investec Asset Management is the largest manager of third-party assets. The narrow SA market means that we cannot opt to sell or ignore every problem company. Importantly, engagement does not only focus on ESG issues, but on the strategic business issues that a company faces. We view ourselves as active shareholders. These are the responsibilities we have as key shareholders:
In summary, the aim of our engagement work is to help preserve and grow the real value of the assets entrusted to us by our clients over the long term. To aid this, Investec Asset Management is intent on ensuring boards of companies focus on the creation and preservation of sustainable value. Investing client capital into an uncertain future requires the investment capability to include governance as part of the fundamental analysis process.
While smoking has moved from glossy advertisements to the dirty secret you hide from your friends, ESG and engagement have not only become fashionable, but are increasingly part of the investment analysis bedrock. There is still much to be done, as data becomes more standardised in areas like carbon disclosure and safety records. This will help better facilitate the integration into company valuations.
Engagement is one of the most powerful tools we have as active investors. We currently focus our engagement on our larger holdings as we believe we can have more impact this way. Of course, we highly value asset owners’ views on our approach to engagement as we are on this journey together. We continuously look at ways to refine our investment process and how best to equip our analysts to get the most from their engagement with companies so that we can deliver the best outcomes to clients.