Is ESG analysis just a matter of checklists, or can it provide access to a useful learning curve for long-term investors?

We believe that a quest for quality should be at the very heart of any equity investment process, because best-in-class businesses have the potential to deliver good returns for investors over the long term with lower volatility.

There are many measures of quality, but one key indicator for us has always been the strength of a company’s environmental, social and governance (ESG) credentials.

We always embed ESG into our fundamental research, because we aim to reduce risk for clients. Quite simply, we believe strong ESG credentials can help insulate against excessive stock-specific risks to which clients don’t need to be exposed. These include climate risk, reputation risk or litigation risk.

We believe in seeking out the best companies, and with a large investment universe of around 450 UK mid-caps¹ from which to choose, there's no need to compromise when it comes to ESG credentials.

We actively discuss ESG issues with the management of the companies in which we invest, meeting them at least twice a year. Conversations can be especially useful and effective when we bring our broader industry insights into discussions about the ESG topics that are most relevant to a particular business.

A two-way dynamic

In our view, ESG should not be a checklist; it should be company-specific. Companies frequently approach us for ESG discussions, and this leads to an interesting two-way dynamic.

Whilst our quality companies are on the path to being first class in ESG, they are also often feeling their way through the ever-changing experience of being listed corporates. We work with them to help and advise about what to disclose, and which standards matter most to investors. We also give our views on board composition, and insights as to what other companies are doing well on the ESG front.

In our experience, one of the biggest benefits of ESG-focused discussions with management is getting deeper insights into the broader investment case for companies. Engagements with companies can provide useful windows into the culture of these businesses and other characteristics that extend beyond ESG factors.

For example, a conversation around carbon emissions can easily touch upon topics such as operational constraints, organisational structure, or capital investment priorities. These direct engagements with management teams are critical for in-house research, especially given that the external market for ESG research is still immature, particularly in the small and mid-cap space.

The sweet spot

Take Hotel Chocolat – a business that research firm MSCI rated poorly. We have deep insights into the company, having been investors since the 2016 IPO. We've also been appreciative consumers of the products for some time!

MSCI looked at Hotel Chocolat through a general food-producer lens, without taking into account many of the ESG aspects that are important to the business. Although MSCI lately upgraded the company to an A rating, in our view this still doesn’t do justice to its ESG credentials.  

Ethical standards are central to Hotel Chocolat’s business, particularly through its focus on cacao farming and its Gentle Farming Charter in Ghana. The charter ensures a strong and reliable living wage for all growers in the programme and facilitates the high ethical standards today’s consumers expect to find behind a premium brand.  It also further strengthens the investment case by enabling a resilient supply of cacao.

Hotel Chocolat’s ESG credentials stem from other aspects of the business too, such as recyclable packaging, food waste reduction, and a positive influence on the broader industry.

Detachment theory

With so much engagement, research and stock-specific analysis, is there a danger of getting too attached to portfolio companies? Certainly, we believe in having conviction and investing for the long term – but we also believe in objectivity.

We can use our quantitative in-house stock screening tool, the Matrix, alongside the above processes. This helps our equity managers to remain detached, particularly when investing in companies over a long period. Such a tool has no emotional attachments to stocks – it doesn’t know what the company does, and it’s never met the management teams.  

Tools such as the Matrix ensure that if an investment case isn’t playing out from a quantitative perspective – particularly where earnings downgrades are in evidence – we can reduce or remove our exposure to the company in question.

In conclusion

We believe that with stock-specific ESG analysis, it’s possible to achieve a virtuous circle of deepening insight and engagement, creating more opportunity for clients, and a positive impact on the world around us. Meanwhile, quantitative tools can help guard against possible behavioural biases on the part of investment managers, especially when it comes to long-term high conviction holdings.

Additional reading

You can read more about how we balance opportunity and risk in small and mid-cap investing in our previous article.

¹ Source: abrdn as at 31 December 2021

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.