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Vontobel keeping ESG blacklist small, says PM

Vontobel keeping ESG blacklist small, says PM

It’s still a common misconception among investors that integrating environmental, social and governance (ESG) standards into their portfolio necessarily means sacrificing returns.

In fact, Citywire A-rated Thomas Schaffner says, building ESG assessment into the evaluation of companies is an important risk-management tool.

‘We can demonstrate that eliminating weak ESG companies improves shareholder returns,’ says the manager of the Vontobel Fund mtx Sust Asian Leaders (ex-Japan) and Vontobel Fund mtx Sust Emerging Markets Leaders funds.

‘Obviously, we cannot identify all the risks, but within our process, our goal is to identify those risks that might have a negative impact on a company’s future cash flows.’

Schaffner’s team strongly believes that taking ESG issues into consideration is a significant help in generating shareholder returns.

In practical terms, this is because companies with high ESG standards are in a position to avoid potentially large fines, are better able to retain talented members of staff, and have less risk of catastrophic reputational problems.

Schaffner has also found that companies that score well in terms of ESG are also more likely to do well when it comes to other operational metrics.

Laying the groundwork

When fighting the misconceptions that still surround ESG, Schaffner has found talking about ‘stock selection’ goes down a lot better than discussions around ‘screening’, even when the process being described remains the same.

‘To overcome misconceptions, we make sure our clients and prospects understand that our process is financially motivated; that we are stock pickers and that ESG is part of our approach,’ he says.

He’s helped in this effort to transition investors’ thinking by the fact that ESG considerations are only a small part of the prerequisites that potential holdings must satisfy.

First, the company needs to have above-average returns on invested capital. Schaffner’s funds only invest in companies with top-quartile profitability in their sector, measured as return on invested capital (ROIC).

Second, the company needs to have strong industry positioning. This is mainly because a company needs to be in the best competitive position to maintain its top-quartile profitability.

Third, the company needs to have an attractive valuation offering a margin of safety to its intrinsic value.

Last but not least, the company's management must demonstrate leadership with regards to effectively addressing ESG issues.

Targeted ESG analysis

Schaffner’s team only invests in companies that have ‘good’ or ‘excellent’ performance on the ESG criteria that are most relevant for each sector.  

Internally, Vontobel’s Matrix team has developed a proprietary Minimum Standards Framework (MSF) that highlights and weights a broad range of company-specific ESG factors in a comprehensive evaluation.

‘We focus on sector-specific ESG issues that we consider material and that might have a significant negative impact on future cash flows,’ Schaffner says.

The sector-specific MSF allows the team to add consistency and discipline to a highly subjective area. Each indicator from the MSF is scored on a scale from one to five, with five being the best.

An overall minimum score for the aggregated assessment of 3.0 is required for a company to be eligible for developed markets (DMs), while a minimum score of 2.4 is required for emerging market (EM) companies.

Schaffner says the 20% lower threshold for EMs was defined by analysing and comparing EM ESG data to DM data from Vontobel’s research providers and Bloomberg.

‘While the governance criteria we consider are the same across sectors, the environmental and social factors differ slightly from sector to sector,’ he says. ‘We do not follow a one-size-fits-all approach.’

Ultimately, Vontobel’s MSF aims to define the most important factors that are likely to influence the future cash flows of companies in each sector. The goal of the framework is to ask a few highly relevant questions rather than asking a large number of less relevant questions.

On the blacklist

Schaffner's approach to ESG generally does not automatically exclude any companies or sectors. However, there are a few exceptions where total bans are appropriate.

Schaffner’s funds exclude investments in companies that are involved in the production of cluster bombs, land mines and weapons of mass destruction.

‘We also have a ban on tobacco companies and utilities where nuclear exposure represents more than 25% of the company’s activity,’ he says.

Knowing that too many exclusion criteria could distort and cancel out the positive effects of ESG integration, Vontobel aims to keep this group of total bans small.

Rather than excluding borderline controversial sectors entirely, Schaffner and his team set high ESG standards for companies operating in these areas.

Internally, the analysts are supported in their ESG knowledge and company assessments by the team’s ESG expert, who provides a second view, uninfluenced by the strength of the financial case.

The auditor is also able to dig deeper into areas of controversy and provide guidance on mega-trends for the industry.

Although the MSF is agreed through a dialogue with the financial analyst, the ESG auditor ultimately retains the final decisive vote in case of disagreement. For the most difficult cases, the team can draw on wider ESG expertise within Vontobel.

‘We have found that having in-team ESG expertise and having it integral to the holistic company evaluation process provides an important value-add for investors,’ Schaffner says.

China in his hands

China has the largest geographical weighting in Schaffner’s funds. As of end September, about 36.8% of Schaffner’s EM fund and about 53% of his Asia fund were invested in China.

‘The attraction for us in China is a very broad universe with large number of stocks available, which increases the probability of finding interesting names,’ Schaffner says.

Additionally, China is home to a lot of companies that have dominant market positions either domestically or across the EM world and that generate high ROIC – the cornerstone of the funds’ investment philosophy.

Negative sentiment towards Chinese equities has also helped Schaffner to identify attractive names in the country.

One name that Schaffner bought at the beginning of the year is Xinyi Glass. The glass manufacturer scored well on environmental standards and practices and is compliant with all the relevant requirements in China.

This bodes well for the company at a time when China is tightening environmental standards, as well as controlling excess supply in some industrial areas.

Carbon charging

One of the important ESG issues in China today is the adoption of carbon costs, meaning companies might pay for their carbon emissions. The move solidifies China’s role as an emerging leader in its fight against climate change.

Last year, China gave out more details of its forthcoming national emission trading scheme (ETS). The scheme will roll out in the energy sector before full implementation from 2020 onwards.

The government is expected to gradually expand ETS to other high-emitting industries such as aluminium and cement in the coming years.

The cap-and-trade scheme will result in high-emitting companies buying and selling emissions credits. Under the trading system, power plants will be issued with allowances to emit a certain amount of carbon dioxide.

The market is set to initially cover around 3.5 billion metric tonnes of carbon from 1,700 stationary sources across China's power sector, including the country's coal plants, according to media reports.

Schaffner says companies in renewable energy, as well as companies that have more efficient processes and necessary environmental measures, are set to benefit from ETS.

Though Schaffner’s funds are not invested in renewable energy, the team is currently evaluating an opportunity to invest in renewable energy.  

Schaffner’s funds do not invest in coal companies at all, but China’s oil companies are investable, albeit the bar is set particularly high.

‘We have set out minimum standards a company must fulfil in order for it to be investable for us,’ he says.

Emerging opportunities, emerging risks

More than in the rest of the world, ESG oversight is vital for EMs as it helps to understand the risks stemming from structural shifts.

EMs are enjoying superior economic growth supported by powerful long-term demographics.

Far from the old stereotype of low skills, low wages and export dependence, EM are pursuing a growth model supported by younger and growing populations, rising per capita income and domestic consumption.

This powerful shift creates a tremendous opportunity for companies servicing those customers.

However, disparities among EM economies and cultures are huge, and the potential to add value through diligent analysis of sustainability aspects is particularly valuable.

‘These disparities are becoming ever greater as the path towards economic maturity varies greatly between countries,’ he says.

‘Our experience has shown that proprietary research, the ability to ask the right questions, and engagement are critical in identifying the best investments in EM equities.’

Market sentiment on EMs remains volatile. However, EM equities appear to have priced in most of negative news at the current levels.

‘In our base case scenario, we believe EM equities remain attractive,’ Schaffner says.

Stable economic conditions and continued disciplined spending on capex by companies will lead to better corporate profitability and thus higher returns on invested capital in 2018, he believes.

‘We still expect a further increase in ROIC by 13% in 2018.’

Turning to valuations, the appeal is obvious. EMs are trading below their average historical valuations, and they still trade at a discount of 30% to DMs based on cyclically adjusted price-to-earnings or Shiller-PE ratios.

Chinese A-shares, meanwhile, are already trading close to multi-year lows.

Trade war: a key risk

Although EMs are discounting it to a larger degree, an escalation of the trade war remains a key risk. ‘In our view, a big escalation would have a negative impact on all major economic blocks,’ Schaffner warns.

In the developed world, large US companies such as Apple and Boeing have a high dependency on China. Apple, for example, derived about 20% of its sales from China in 2017.

Economists expect China’s GDP growth to slow in 2018 to around 6.5% from 6.9% in 2017 on the back of ongoing supply-side reforms, stricter enforcement of environmental standards and deleveraging of the financial sector.

However, it is important to understand that this slow-down is driven by the regulator. China could start easing measures in the property market or further reduce the reserve requirement for banks should growth slow too aggressively.

What’s more, these reforms should lead to a reduction in overall risks in the long term, Schaffner says. This should in turn drive improvement in corporate profitability, offsetting the slightly lower growth rate. 

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