How the Process of Identifying Environmental, Social & Governance Issues Can Point the Way to Enhanced Shareholder Value Targets
By Martin Currie
As bottom-up investors, our process starts at the company level. We subject all candidates for inclusion in our high-conviction portfolios to rigorous fundamental analysis and peer review. ESG analysis is embedded in this assessment, influencing key assumptions such as the cost of capital, revenues and expenses. From this we can seek to estimate a company’s intrinsic value.
Governance is a fundamental determinant of long-term performance, as is a company’s environmental and social track record, making it a reliable proxy for wider sustainability.
Our approach is backed up by research showing a clear link between a firm’s integration of material sustainability factors and enhanced shareholder value. Ultimately, the best gauge of success is how a fund performs relative to its peers – and ESG can play a key role in achieving investors' goals.
Identification: We start with a list of factors we may consider as part of our fundamental analysis. The level of research and engagement varies depending on region, sector and, critically, the materiality of the issues in question. The overarching aim is to assess the extent to which ESG factors will contribute to/detract from the long-term value of a firm.
Governance: We value transparency and clear, accountable structures, paying attention to the extent to which a company demonstrates alignment with the interests of long-term investors. Primary issues include board leadership, diversity and independence; management remuneration; shareholder rights; succession planning; and accounting and audit standards.
Environmental: Knowing how a company manages potential environmental issues helps us understand how it prepares for regulation and disclosure requirement changes. Concerns include pollution, water usage, climate change (emissions), energy efficiency and resource management.
Social: How a company treats its people, customers and other stakeholders can give valuable insight into its culture – a good proxy for long-term business success. Material issues in this area can include data protection and privacy; equality and diversity; community relations; human capital management; product safety and liability; and supply-chain management.
Integration: ESG factors are integrated into our analysis and decision-making process. We make qualitative and quantitative assessments of issues that are material to long-term performance.
Materiality is a concept we use frequently. In simple terms, it refers to the strength of the relationship between an ESG factor and corporate performance. Some of this is common sense: carbon risk is clearly more material to oil & gas firms than to IT-services, for which data protection and cybersecurity are likely to be more material. Other instances may be less intuitive.
To make the best use of our research time, we have created hierarchies of these material issues, industry by industry. We can gauge whether managements are focusing on the right areas. The challenge is to translate this information into numbers for modeling key financial variables.
Active Ownership: As an active manager of long-term, concentrated portfolios, we place a significant emphasis on stewardship. Engagement is a key element. We are motivated by a firm belief that this both helps protect, and enhance the risk-adjusted return on, our clients’ capital. We build strong relationships with investee companies and engage in a constructive manner.
While we typically engage in private (250 companies in 2017), most often on governance issues, we also join collaborative efforts, particularly when likely to be more effective than acting alone (19 major 2017 collaborations). Our decision to pursue collaborations also takes in the specific nature of the issues, and the degree of alignment with the other investors.
The nature of our active engagements from 2017 breaks down as:
Governance Only: 64 percent
Environmental Only: 17 percent
Social Only: 10 percent
Overlapping ESG Issues: 9 percent
Voting Activity: A key component of stewardship, when proxy voting on behalf of our clients, we consider the long-term economic impacts. Many themes continue to be important, particularly remuneration: there is a broad push to increase transparency and bring incentive plans in greater alignment with the long-term interests of shareholders.
“Overboarding” has been a common concern, with many directors still taking on unrealistic numbers of commitments. Meanwhile, the long-standing issue of board structure has kept cropping up, particularly regarding independence and diversity.
With pressure around climate change (“carbon risk”) disclosure increasing – unsurprisingly focused on the fossil fuel sector – we remain supportive of many initiatives. As always, we review all meeting proposals case-by-case, with our clients’ best interests at the heart.
For the most part, we vote with management – but the exceptions can prove important.
Total number of shareholder meetings attended: 685
Meetings at which we voted in line with management: 454 (66 percent)
Meetings at which we voted against management on at least one resolution: 231 (34 percent)
Total number of resolutions voted upon: 7,541
Resolutions voted in line with management: 7,029 (93 percent)
Resolutions voted against management: 542 (7 percent)
Categories for votes against management:
Director related: 43 percent
Compensation: 21 percent
Governance & control: 21 percent
Business matters: 10 percent
Other: 5 percent
Pan-Asia: 40 percent
Europe: 25 percent
United States: 21 percent
Rest of the world: 12 percent
Middle East & Africa: 2 percent
Martin Currie is an international equity specialist and a subsidiary of Legg Mason. The firm’s opinions are not meant to be viewed as investment advice or a solicitation for investment.
©2018 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC is a subsidiary of Legg Mason, Inc.