Less pain more gain

The source of my pain? An interview I read a while ago with a particularly impassioned ESG advocate (although I don’t think he was a fund manager). The topic of conversation was a controversial company that has experienced a substantial share price drop as a result of material sustainability issues. My bugbear was with the response of the ESG advocate though. I’ll paraphrase for convenience but when asked whether the stock might now represent a great buying opportunity the advocate replied:

“The whole point of ESG investing is to take pain. We should be willing to underperform if this means avoiding companies that do harm”

Ouch… that hurts. There’s the pain.

Who knew sustainable investing was a masochistic pursuit (not me)!

For me this is the clever work of a cynical journalist cherry picking sentiment, and it totally misses the point. For me, sustainability analysis involves assessing the sustainability of products and practices and the rate at which these factors improve (or regress). For me, it’s a meaningful alpha generating tool.

So back to “taking the pain”…do we think that’s a factor of sustainable investing. No. I see it this way. The point is to:

  1. a) Avoid the pain
  2. b) Identify disruptive sustainable growth opportunities before the market does

You may have to suffer through the short-term underperformance and watch companies and subsectors that we deem to be unsustainable outperform. BUT that’s very different from deliberately underperforming as the above quote implies.

If our analysis is correct (and before we get ahead of ourselves – no analysis is always correct), outperformance of an unsustainable company will be brief and its unsustainable products and/or business practices will be found out in the end, unless it takes steps to address these shortcomings. By definition, something which is unsustainable, will not sustain. And if it is not going to sustain, it is never going to be a good investment. So there you have it – in an unsustainable company you may get a short term speculative trade (perhaps), but never a good investment, in my opinion.

If nothing else, the original quote does teach us one thing – that as a group, sustainable investors need to do better at communicating the multiple advantages of sustainability. Yes we are intentionally trying to have positive impact with our clients’ capital, but it is not simply an ideological venture with a performance cost attached. So what would my response have been to such a question? Hopefully something like this:

 “Is the product that the company sells getting more sustainable? Is the company demonstrably improving its practices to address its material sustainability risks? If not, I will never think it is cheap enough to be a great investment opportunity.”

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Open and Honest

Ever worked in a company that required you report ‘near miss’ events? That is, events that could have or nearly did result in an accident. The rationale is straightforward; an open reporting culture and investigating the near misses should help avoid the real thing, which at the extreme can be both fatal and catastrophic. In heavy industries where safety is critical, ‘sweating the small stuff’ is important.

Slightly different, but there are safety parallels in a recent study* which looked at whistle-blowing data from US listed companies. A requirement of many markets (for example, Sarbanes-Oxley in the US), whistle-blower systems are intended to provide a secure and anonymous means to report issues and provide an alternative to the traditional reporting and monitoring mechanisms that companies employ. And they are important, because employees, as insiders, are best placed to identify inappropriate behaviour within a company*.

What did the study find? In a nutshell, evidence of more whistle-blowers is a good thing at a company. Counterintuitively, more internal whistle-blowers doesn’t mean more (frequent or serious) problems. Rather, it showed (in US companies at least) that the more employees use internal whistleblowing hotlines, the less lawsuits companies face, and the less money they pay out in settlements. Use of whistle-blowing is actually a sign of open and effective communication channels; employees believe that problems will get sorted. Conversely, it’s not hard to imagine that when management abuse these processes (insert name of UK-listed bank here), this belief is eroded. Avoid the ‘accident’ (and the associated public relations disaster), address internally and learn from your mistakes.

And from a governance perspective, did the study identify any particular company traits? Yes. Autocratic executive management teams with governance protocols that limit minority shareholders are less likely to pay heed to these systems. As are fast growing companies (where other studies have shown that accounting misstatements are more prevalent) which is important for us to bear in mind given our focus!

Finally, remember, this is for companies in the US, a nation which psychologists and sociologists would classify as having ‘low power distance’*. Psycho-babble what? Power distance is the ‘extent to which the lower ranking individuals of a society accept and expect that power is distributed unequally’*. This been measured on a country by country basis and it has been found that many developing countries have ‘high power distance’. To stretch the safety parallels to their limits, safety stats in developing markets often look great. At face value, the data says, ‘nothing to see here’. But accidents often go unreported because employees are (more) respectful and submissive to their employer. Taiwan, India, Japan et. al all require whistle-blowing systems and processes like the US does, but I imagine the hotlines in these countries probably don’t get a lot of calls.

In case you were in any doubt, open and honest corporate cultures work best. If management teams are targeting ‘zero’ whistle-blower reports they are missing the point.

*Stubben, S. and Welch, K.T, (2018); Evidence on the Use and Efficiency of Internal Whistleblowing Systems
*Dyck, A., Morse, A., and Zingales, L. (2010); Who blows the whistle on corporate fraud?; The Journal of Finance; 65(6), 2213-2253.
*Outliers: The Story of Success; Malcolm Gladwell (2008)

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Subsidised Confusion

I recently attended a conference in Germany on ESG investing and its potential to have a positive impact on the world. Various issues were discussed and whilst there was agreement on some themes, there was divergence on others. This is unsurprising given the diverse approaches that can be taken to sustainable investing and is in keeping with the point that we often emphasise, that the devil really is in the detail.

So what were the talking points?

Why pay a premium for sustainable products when you could just buy a cheaper one?

One delegate insisted consumers wouldn’t pay a premium for a product just because it was sustainable. I fundamentally disagree with this from a philosophical perspective and evidence suggests that consumers are increasingly conscious of the product impact of the things they buy – especially millennials, who not only want to buy sustainable products but want to buy them from sustainable companies. 

I’m confused, is this sustainable or not?

There was an acknowledgement that sustainable investing can confuse clients… A number of managers then proceeded to give confusing presentations with tenuous stats, like ‘investing in a sustainable fund is 27 times more effective for the environment than cycling to work’ or ‘our portfolio prevented X number of sick days from work’. 

How on earth are clients meant to judge the effectiveness of sustainable investments when they are bombarded with stats like this? Whilst transparency and reporting on material factors is undoubtedly positive, it’s vital to keep these realistic and understandable. We look at the individual merits of each company to judge whether it is making a positive contribution. We might not always be able to measure that in lives saved or tonnes of CO2 emissions avoided, especially since these benefits can be indirect and further up or down the supply chain but by thinking about it holistically like this, we can be sure that each company we invest in is doing things the right way. 

Maybe what we need is more red tape

The idea of more regulation for sustainable funds was floated. There was little support for this other than a high level framework which respects the diversity of the sector.

The European Commission has taken an interest and has suggested that more specific disclosure requirements for sustainable investments are needed, stating “the overall sustainability-related impact of financial products should be reported regularly”. I am cautious on this for the reasons stated in the above section. I am all for transparency and reporting relevant data but setting specified metrics for such a nuanced subject has its dangers.

Throw money at it?

One suggestion was to subsidise sustainable investment funds to encourage people to invest in them… No, no, no. I disagree with this on a number of levels. For a start, it would result in ‘greenwashing’ where funds make a token, tick box effort to appear sustainable to qualify for the subsidy. Having more high quality managers investing sustainably would be a positive – as long as they do this in a genuine way and for the right reasons.

So, lots to take away and mull over. Debate is healthy and the fact that everybody has their own way of thinking about sustainability is part of the beauty of it. For our part, we will continue to focus on the detail and the nuances and share our insights and statistics where possible… Just don’t expect us to tell you that investing in a sustainable fund will save 14,521,325 trees, which will benefit from the 20,942,768 gallons of water saved and which you will be able to appreciate due to being ill in bed 17 fewer days per year.

About the author

Iain Snedden is an investment specialist in the equities team. He has responsibility for representing the firm’s equity capabilities both within and out with the firm, with a particular focus on our suite of global equity products. This involves ensuring colleagues and clients are kept up to date on developments within the funds and the wider market. Iain joined us in 2015 to work in the Client Management team with responsibility for a portfolio of UK-based institutional clients. Prior to that, he worked at Baillie Gifford and held roles within the client accounting and business risk functions. Iain graduated from University of Edinburgh with a first class honours degree in Accounting and Business Studies. He has 8 years’ industry experience (as at 30 November 2018).


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Heuristics are simple efficient rules that we all use on a daily basis. We have all learned these through experience, and often they aid our decision making. They are especially helpful in making decisions with the limited resources we all have, particularly in terms of time.

As an example: many people do not have time, or perhaps the inclination, to consider the various parties’ policies and form an opinion on their impact when voting in an election. Often the quick heuristic (a rule of thumb in this case) used is “Do I like / trust this politician?” (a single factor decision). This is far easier to evaluate than the party’s position (set against other parties’ positions) on the economy, healthcare, crime, education, etc. (a multi factor decision). Even those who do not have a strong view on political matters are highly likely to have a view on whether they like a particular candidate (or not). Often a referendum result can be dictated by the popularity of the PM responsible for asking the question, perhaps reflecting this tendency. It is easier to decide whether we like David Cameron (or Boris Johnson?) than to examine the full implications of a Brexit vote.

As is ever the case with rules of thumb, nuances are lost, which can sometimes lead to suboptimal outcomes. Similarly, when we look to apply rules of thumb to Environmental, Social and Governance (ESG) investing, we should be wary of unintended consequences. For example, where portfolios are not already excluding, let’s consider one of the ESG rules of thumb that has been suggested for investors to manage their coal exposure; specifically not investing in any company with more than 10 gigawatts (GW) of electricity production from coal-fired power stations.

Let’s quickly evaluate a company that would fall foul of this limit. If we take the Italian utility Enel, its installed coal capacity of 15GW in 1H2018 would dwarf the total installed capacity of many other utilities. However, Enel has embraced renewables generation more than many others in the industry (some of which, crucially, would pass this test), focussing their investments on green energy and grids (43 GW in installed renewable capacity). Even so, because of their sheer scale, they would fall foul of the coal capacity rule of thumb. Despite not investing in new coal plants, and despite reducing coal generation by 14% year-on-year in their first half results.

Taking a company which would pass this limit rule: CEZ are a Czech utility which uses lignite (also known as “brown” coal) in their coal and lignite power plants. Lignite is widely considered to be worse than coal from an environmental perspective and comprises 76% of CEZ’s thermal and 38% of total generating capacity. They also expect new and upgraded lignite plants to continue to operate for 25 years. Contrast this with Enel which talks about ‘renewables being the driving force of growth’.

In a carbon constrained future, which is the better choice? Enel or CEZ? We would argue it is Enel, but it is CEZ that passes this test! And even though most of our portfolios do not have coal powered electricity production restrictions, we have actively made the considered choice to invest in ENEL (we passed on the recent deal for CEZ).

This is taking only one rule of thumb, so is a single factor evaluation. However, it shows that nuances can be overlooked.

This is why our long history of running ethical funds has led to a multifactor approach in our ESG evaluation, and why our preference remains to evaluate the drivers behind the exclusions, rather than applying a heuristic rule of thumb.

About the author

Kenneth Ward is an investment manager in the Fixed Income team, specialising in the utilities and mining sectors. He initially joined Kames Capital in 2010 from RBS Trustee and Depositary Services, where was a securities analyst, and had been working as a performance analyst between 2010 and 2014. Kenneth studied Mathematics at Heriot-Watt University and is a CFA charterholder. He has 11 years’ industry experience (as at 30 September 2018).

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The affordable housing conundrum

The UK needs more affordable housing

Development of new council housing has fallen off a cliff over the last half century. Last year there were 1,155,285 households on local authorities’ housing waiting lists in England alone. Local authorities no longer have the resources to be significant developers of social housing and the burden now falls to private house builders, and, particularly for social housing, the Housing Association (HA) sector.

New homes built by private and social sectors in England

Source – Ministry of Housing, Communities and Local Government

HA’s have been somewhat reluctant participants in the development game; happy to cautiously grow their housing stock, but not picking up the slack from the dearth of council housing. In addition, government policy has, at times, not exactly been favourable towards the sector. However Theresa May seems to be more predisposed to the social housing sector. Recent proposals indicate rent levels will return to being linked to inflation in the coming years, and there has even been a return of government grants, albeit relatively small, to fund new social housing development. The quid-pro-quo for this friendlier relationship is that housing associations have to get out and build new affordable homes.

Many in the sector, especially the larger associations, have heard the call. They have responded with a spate of mergers designed to pool resources and flex balance sheets to launch ambitious development programmes. Some of this will be funded by government grants, but much of will come from debt raised by HA’s in the corporate bond market. Indeed, they have become some of the most prolific issuers of corporate bonds in the UK market in recent months. It’s rare if a week goes by that my colleagues and I don’t have a meeting with an HA looking to raise fresh bond market finance.

New development programmes often consist of a mix of “tenures”. Some new homes will be for traditional social housing, some will be for shared ownership schemes, and some will be for outright sale on the open market. The latter subsidises the former and is all very sensible and commendable. However, from a creditor’s point of view it introduces more risk. Developing homes for outright sale exposes them to potentially adverse movements in house prices, especially in volatile markets like London. This increase in risk has been reflected in a downward drift in the credit ratings of some of the larger corporate bond issuers in the sector. When I first started analysing the sector over a decade ago, the small number of issuers generally had very strong credit ratings – usually in the broad AA range. Today, there are still a few who can boast an AA rating but they are the exception rather than the rule, as the table below shows.

Part of these moves reflect the downgrade of the UK’s sovereign rating (to which HA ratings are linked) in recent years, but the increase in development risk has taken its toll on the credit rating of many an HA.

We have long been providers of finance to the housing association sector, often through our ethical fund range, where it will continue to be an area of focus. However, now, more than ever, we are being increasingly selective about where we invest in this sector. We see most value in those HA’s with a proven track record of development through different property cycles, and on those whose focus is on developing primarily social housing, without taking outright sale risk.

HA’s have a tricky path to navigate: developing new housing stock to keep policymakers happy whilst simultaneously maintaining good relations with bondholders on whom they rely for finance. The two aren’t mutually exclusive, but will provide a difficult challenge for management teams in the coming years.

About the author

Iain Buckle is an investment manager in the Fixed Income team with responsibility for credit analysis, particularly securitised and structured finance assets. Iain is the co-manager of several funds with a primary focus on sterling credit mandates. His funds include pooled and segregated mandates and included in our ethical bond franchise. As an experienced investment manager Iain is responsible for overseeing the institutional pooled and buy-and-hold portfolios managed across the team. Iain joined us in 2000 from Baillie Gifford where he was a fixed income analyst, and has 21 years’ industry experience*. He studied Economics at Heriot Watt University.

*As at 30 September 2018.

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