We view ESG as a source of investment risk when assessing a company. Much of the value of a company comes from intangible assets like intellectual property and reputation. It is vital that our analysts have a good understanding of those risks that could damage the company value, many of which are within the ESG sphere such as poor working conditions or safety standards which could potentially undermine a business as can reputational damage from bribing customers, poor data protection or environmental damages.
Once a company has been selected for our Universe List, it remains there until the right entry point can be achieved. We essentially capitalise cash generated 5 years out to put a price on the business, compare it with today's price and seek an investment rate of return (IRR) of 15% p.a. Sustainability factors are also considered at this stage of the process. The Universe List consists of approximately 250 companies. Companies with a 1 rating have the greatest predictability and better corporate governance. For these businesses we only seek a 12.5% IRR i.e. we will accept a lower margin of safety due to lower risk factors being present. The majority of companies are rated 2 and a 15% IRR will be targeted. Companies with a 3 rating are those whose corporate governance may leave some concerns e.g. Cayman Islands holding company and as a consequence we look for a 20% IRR. If we have an issue with safety standards, working conditions etc., we would probably not hold the company unless this was being addressed (in which case we would rate it a 3 and look for the higher IRR).
The portfolio will be constructed with the lowest risk possible. Given the choice of buying a position offering a 12.5% IRR vs one with a 20% IRR, we would select the former.