For all the talk of long-term investments, the fact remains: many equity investments are still driven by short-term movements in stock prices. All too often, investors view equity risk through the prism of stock market volatility and the likelihood of any given stock price falling or rising. Equity price gyrations are often misunderstood and perceived by investors as both a measure and a symptom of risk.
However, we believe risk is not synonymous with stock price volatility, but instead resides at the underlying business level, manifesting itself as operating risk, stranded assets, financial leverage, poor management and environmental, social and governance (ESG) deficiencies. It is the latter that we aim to examine in closer detail in this article.
Assessing risk through ESG factors
We believe forward-looking ESG risk analysis plays a central role in understanding the true scope of asset and investment risk/reward scenarios. By assessing risk based not on stock price, but rather the company’s potential for permanent loss of capital due to issues such as ESG failings, investors may be better able to create a portfolio comprising securities of both quality and value, potentially providing superior risk-adjusted returns. This integration of ESG research with more traditional forms of fundamental analysis therefore can give us a better appreciation of the upside and downside potential offered by individual companies.
The gap between companies which follow ESG best practices and those who don’t will likely widen further as governments increasingly take regulatory action over ESG issues such as climate change. Companies with a structured plan in place to make improvements in these areas will likely be best positioned to outperform the market. Moreover, early adopters are likely to increase their focus on innovation while strengthening their credibility among investors, customers, and employees and benefiting from stronger brand management. Those who don’t take action may find themselves playing catch-up on regulatory changes and risk reputational damage among investors and consumers.
ESG issues to consider when assessing business risk
Operating risks of the business
Sustainability of the business
Management of the business
Costs incurred due to increased ESG regulation
Sustainability of operations
Land and ecosystem
Toxic emissions and waste health and safety
Recruiting and managing a diverse and skilled workforce
Board composition (gender and racial diversity)
Management of ESG issues
ESG integration and sustainable value creation
For ESG investors, the central focus is on sustainability, a condition of resiliency represented in company fundamentals and management effectiveness at managing material risks, which, in aggregate, gives companies a better chance of thriving in the future. It’s telling that, at the height of the volatility brought on by the pandemic in March 2020, a widely cited U.S. mutual fund industry study found that four times more sustainable funds finished in the best quartile than in the worst quartile of their categories during the first quarter.¹
As a result, we regard sustainability as a precondition for value creation.
- Integration. We integrate ESG into our process by combiningactive investment management with deep understanding and analysis of sustainability issues. By leveraging a range of ratings and data points, we create a proprietary ESG risk exposure rating for every company in the investment universe. This approach is closely aligned with our investment philosophy around business value creation, and as a result each company is scored regardless of market, sector, geography, market-cap or time.
- Stewardship. We view strong stewardship as inseparable from good investing. Strong stewardship practices are vitally connected to enhancing the resiliency of our clients’ assets, our client relationships, and the health of the markets overall. Without strong stewardship, an investment’s integrity can be compromised; in turn, the asset manager/asset owner relationship can suffer, and the smooth functioning of financial markets can break down. That’s why we work closely with companies to improve their environmental, social and governance standards and performance over time.
- Collaboration. At Manulife Investment Management, we appreciate the importance of ESG analysis and have a large internal ESG research team that works both independently and in concert with our boutique asset management teams. As the Value Equity team, we've partnered closely with our ESG colleagues to better understand the risk/return potential of our companies. We believe that asset managers that invest the resources into building strong ESG research teams will be at a distinct advantage in the asset management industry of the future.
In a world where markets are so susceptible to short-term swings, an integrated ESG approach can help investors to unearth companies with demonstrable long-term value. We believe that focusing intently on underlying business risks, which increasingly include ESG factors, can help investors sidestep the slings and arrows of short-term volatility, get a clearer picture of where real business value is being generated – and reap the benefits of potentially more consistent returns.
Case study: ESG engagement in action
We found an ESG opportunity that we believed had been significantly mispriced by the market. The company did not screen well on corporate governance and disclosure, resulting in poor ESG scores and limited initial investment.
We performed our quantitative and qualitative due diligence on the company, including multiple meetings with management to find out more about why the company had scored so badly on ESG risk and assess the management team. We discovered that the company was already in the process of addressing some of the ESG issues that had been flagged.
We felt that the company wasn’t being given credit for what we regarded as best-in-class ESG practices due to superficial screening and a lack of disclosure on non-relevant factors. Our engagement with the company showed better than perceived management quality and provided confidence in the sustainable practices that had been implemented. The portfolio weight in the company was increased following our engagement.
1 “Sustainable Funds Weather the First Quarter Better Than Conventional Funds,” Morningstar, April 3, 2020.
The opinions expressed are those of Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Manulife Investment Management disclaims any responsibility to update such information. Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management Limited, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Unless otherwise specified, all data is sourced from Manulife Investment Management.
Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.