Water – Risks of a Vital Resource
At Vontobel Quality Growth we have managed a long-term investment approach consistently for more than twenty years. When investing for long holding periods we have found it is essential to understand the impacts and risks associated with management choices around environment, social, and governance issues. However, for context, we believe if a management follows best ESG practices or not, it does not mean there will be an immediate impact on the company’s performance – but that over a few years the likelihood of an impact is much greater. We see ESG as an integral part of a long-term investment process, much like safety is to driving. If you drive without using the mirrors, it does not mean you will get to your destination quicker or slower, but with time the chances of a costly encounter may rise.
Our approach to investing is built on a philosophy of “Quality Growth”. This is delivered through a fundamental bottom-up process that integrates elements of growth, predictability, stability and valuation discipline over a longer term context. An important driver of long-term returns is the sustainability of underlying earnings growth. For a company to sustain its growth and reach its long-term potential, we believe managements need to maintain a healthy balance between its core stakeholders that include its customers, employees, suppliers, and the environment. We believe the many elements of ESG make up an integral part of the fundamental research that supports an investment thesis.
We regard ESG as important in avoiding potential risks to future performance. ESG risks we regard as significant are researched individually in line with our bottom-up research process - which does not rely heavily on quantitative screening past the initial search for investment ideas.
Sustainability risks vary by company situation. For example, if a company is controlled by a core shareholder, the investment analysis will involve research work around governance and incentives of the controlling shareholder, and how they align with long-term minority investors. Another example would be food and beverage companies that may have a strong need for focus on water sustainability where it represents a vital ingredient.
We look at a broad array of ESG risk red flags bottom-up, business-by-business. Potential red flags vary considerably by industry, geography and company. When we start our 5-step investment process around a potential new investment, we begin with a screen that includes reviewing historic performance around a number of metrics. Additionally, we check for ESG red flags to see if there are any quantifiable risks that should be considered for the next phase of the process.
In the second step, we dig into how the company has achieved its track record and the quality of the business and management. During this stage, we research a number of established ESG-related issues such as governance structure, environmental risks (e.g. water security for food/beverage companies) and social issues such as supply chain risks (e.g. forced labor risks).
Importantly, we are constantly aware of what might constitute an ESG red flag if we see it. Many ESG risks (real world risks) are not published; therefore, they cannot be quantitatively tracked. When we sense there might be an issue of consequence, we focus with deep dive research. For certain subjects or issues we will engage directly with management, and for others we may deploy one of our investigative analysts. This way, we can try to get our arms around the potential risk from a red flag.
Management decisions are central to a company’s performance, as well as how it handles its ESG risks.The board sits at the head of the management pyramid. Its primary function is to bring a team of expert individuals together to make the best overall decisions for the current and future direction of the company.
Social focus reflects the company’s relationship with its human capital and the broad community touched by its presence. One of the substantial risks for consumer facing businesses in particular, is its reputation, its ‘brand’.
For us, active stewardship includes the mind-set of acting as owners while the shares are held, and that strong governance provides the backbone to a sustainable business. To this end, engagement with managements and proxy voting are important elements of our long-term focused investment process and are related disciplines.
We believe regular communication with our investment company managements is of great importance. We are not activists and do not invest with the goal of generating returns from changing how a company is run. However, as active stewards we communicate with the management teams of our investment holdings, will look for clarification, and on occasion changes if we become uncomfortable with ESG or other issues. We typically communicate with managements in private. Only on rare occasions would we consider making public statements on issues where we disagree. We carefully select from a range of issues and levels of engagement. Some engagements are relatively short and simple, where a quick conversation can satisfy our needs. Other engagements can be more involved and may extend over longer periods of time.
As stewards of capital, we regard the accountability of the board to a company’s shareholders, and of management to the board, as vital links to help protect the long-term interests of clients. In order to fulfil this responsibility we have implemented proxy voting procedures and a proxy voting policy. Proxy voting procedures include hiring and verifying the competency of a proxy voting service and the process to avoid conflicts of interest. Our voting policy has been adapted to cast votes in a way we believe will support the best interests of our clients over the long term.
We use ESG issue-related data in a number of ways. There are some areas where ESG issues are broad and affect many companies such as governance structure or around the management of scarce natural resources. When issues are broadly shared across the investment universe, we can benchmark a company’s standing against a benchmark for a relative picture. However many other ESG issues are company, industry or region specific.
We believe it is important to understand the potential issues and adjust for them individually, rather than relying on broad ESG scores. We find value in the broad scores, but mostly view them as a strong starting point for further investigation of red flags rather than an end-point factor.
We purchase third party research from a number of providers but monitor our individual holdings internally. Third party providers provide scores for our portfolios against peers and the benchmarks for internal and external reference, but primarily we use the data to search for red flags of risk.