Consideration of environmental, social and governance (ESG) risks in investment decisions has gained momentum. But aside from fulfilling socially responsible mandates or a moral obligation, should any investment manager – let alone a credit manager who has no shares to vote – really care? After all, a manager’s primary fiduciary duty to clients is to make money and avoid loss.
At Hermes Investment Management, we have learned however, that consideration of ESG factors cannot only help in providing a more comprehensive view of risk, but in turn also improve a manager’s ability to deliver market-beating returns. Based on our experience as credit investors and on research carried out in-house, we have found that analysing ESG factors as part of the investment process can enhance overall performance.1
Although the interests of shareholders and creditors do not always converge, poor ESG practices can erode enterprise value – which is negative for both shareholders and creditors alike. Therefore, in addition to assessing and pricing operational, financial and liquidity risks, we believe investors undertaking ESG analysis enables the more comprehensive assessment of a company’s prospects.
In January 2014, Hermes published the results of a study conducted on the impact of ESG risk on shareholder returns. The findings provided insufficient evidence to link stock performance with social and environmental metrics, however, it did find that stocks with poor governance typically underperformed.
During a five-year test period ending in 2013, companies with the worst governance standards underperformed in 62% of the months compared to peers in the MSCI World Index2 (see Chart 1).
Chart 1. Poorly governed companies tend to underperform
The monthly average return of stocks in the lowest governance decile relative to the average return of companies in the MSCI World Index, from 31 December 2008 to 31 December 2013. Source: Hermes
Interpreting the data, it was concluded that good governance does not guarantee superior stock performance. Rather, avoiding companies with poor governance provided a better chance of avoiding ‘blow-ups’ – companies that fail due to inept management or regulatory scandal.
So how can credit investors detect poor governance? In the aforementioned study, the following factors were considered: board independence, poison pills, remuneration, independent directors, combined chair-and-CEO role, risk management, business ethics and proxy voting. These metrics could be applied to most investment-grade credit issuers because they are often listed companies and must disclose this information. Similarly, although the study analysed equity performance, the conclusions about poor governance can be applied to investment-grade issuers, too.
But many issuers are private and, as such, these considerations are not relevant. A company could be 100%-owned by a private equity firm, which controls the board and thus the direction of the business. Little consideration is given to ‘independent’ views. In some cases this is not problematic and the interests of all stakeholders – equity and credit alike – are aligned. In other cases, however, shareholder actions are antithetical to the interests of lenders.
What’s important is that credit fund managers do not take a dogmatic approach to credit-negative events. Instead, they must be analysed in the context of the financial strength of the business itself. Moreover, systematically avoiding all companies that have high ESG risks would preclude investment in companies with improving ESG characteristics. Rather, a credit fund manager should price-in the risks of poor ESG exposure, and look favourably on companies aiming to improve their management of ESG risks.
What can we conclude from the research? That companies with chronically poor governance tend to underperform. While fund managers should watch for signals of governance risk, they must also keep an eye out for improving ESG stories that are underappreciated by the market and present an investment opportunity. As credit fund managers, we should not be dogmatic in judging corporate behaviour. Rather, we must assess and price-in ESG risks in the context of the overall strengths and weaknesses of underlying businesses and the broader sectors in which they operate. By integrating this in their investment processes, credit managers gain an even better chance to outperform the market and their competitors.
Fraser Lundie, CFA, is co-head and senior credit portfolio manager for Hermes Credit
1 and 2 “ESG Investing: Does it just make you feel good, or is it actually good for your portfolio?” by Hermes Global Equities, published January 2014.