How institutional investors can determine material ESG factors

Environmental, social and governance factors are an important dimension of fundamental analysis, said Jenn-Hui Tan, global head of stewardship and sustainable investing at Fidelity International, when speaking at the Canadian Investment Review’s Investment Innovation Conference in November.

Traditional fundamental analysis captures topics including financial performance, the pricing power of a company, its competitive advantages, the size of the market, its sensitivity to macro factors like interest rates and the effectiveness of its board, he noted.

On the other hand, looking at ESG fundamentals would capture topics including an analysis of a company’s impact on its environment, product safety, product responsibility, employee well-being and engagement, supply chain robustness and resilience, and board diversity and independence. “[Putting] these two things together, we feel, captures a fuller range of fundamental factors, which will impact the financial performance, so the revenues and the margins, the cash flows and the balance sheet of the companies, and therefore . . . the long-term value creation that is enjoyed by investors.”

The average lifespan of a company is falling, added Tan. “And what that implies is that for the purposes of investment, the most important thing about a company’s valuation might not be its profitability today or tomorrow. It might be how long it enjoys that profitability for, or what is the duration of the company’s business in effect.”

Another key change in markets of late is that the intangible value of companies comprises the majority of their market value, he added, noting investors need much more than financial data to analyze companies correctly.

But when looking at incorporating ESG into investment research, not every ESG issue is equal or important to every company. Depending on sectors, sub-sectors and business models, different ESG factors will have different materiality, he said. Plus, investors can look at key performance indicators to measure key issues and assign weights and rankings to each company relative to its peer group.

Further, pension plan sponsors should consider the range of different ways of considering ESG ratings across various providers and the importance of not just taking a rating and jumping to conclusions. Rather, plan sponsors should think about what information an ESG rating is actually conveying, he said.

At the end of the day, plan sponsors must consider a lot of information when it comes to ESG ratings.

Tan’s advice for plan sponsors is to understand the ESG philosophy of their appointed agent and ensure it is aligned to their own beliefs. Then, plan sponsors should look at how the philosophy is implemented and outcomes. “That to me is a better framework for thinking about assessing ESG for asset managers or agents rather than simply taking a third-party score and saying, ‘Oh, well this says to me it’s a triple-B or C-minus or whatever.’”