Taking an active management approach is a central part of our investment proposition, and, as a result, our funds are able to take a selective approach to stocks by only investing in companies with the necessary characteristics, in the team's opinion, to be sustainably successful over the long term.
Generally, funds cannot adopt an overly prescriptive approach, as they are charged by clients with beating, in a prudent and risk-adjusted manner, a benchmark index that encompasses a broad range of companies, with widely differing standards on these issues. What they can do is analyse companies with these issues in mind and recognise that management's attitude toward these challenges will be part of identifying "best in industry" practices, a key factor in delivering sustainable and superior returns to shareholders. ESG issues will rarely be the sole driver behind any investment decision. Instead, ESG considerations provide further insights into the risks and opportunities inherent within a company or sector and gives greater colour to our teams' fundamental analysis and thus plays a part in informing their judgement to buy, sell or hold. Material ESG factors are therefore integrated into investment decision making. These considerations may be stock-specific issues or equally they may be macro risks. What is clear, however, is that companies actively pursuing 'good' ESG performance will often have the ability to become market leaders, with true franchise value, either through the perception of the sustainability of the brand or through product innovation, driven by finding solutions to some of the key issues in their industry.
The Hermes Global Equities team would generally not expect their strategies to include stocks with a low ESG score unless there is evidently improving performance; however, the universe would not necessarily be explicitly reduced through the team's analysis. If a company recommended by their Model had significant company-level ESG risk, the team would look to invest in a similar company without those risks if an alternative was available. If not, they might look to underweight that position. The emphasis on sustainability and responsibility is further enhanced by the integration of ESG considerations in the investment process, particularly governance, which is one of the characteristics embedded in their Model. A company may rank highly in every regard, but if it displays poor corporate governance or is over-leveraged, then its overall score will be significantly reduced. The portfolio is also rebalanced monthly and will incorporate any new information that becomes available, including ESG information that may cause a company to fail. In addition to the monthly rebalancing, the team may sell a stock if there is a large change in the model's ranking of the stock or if there is significant news flow that would cause the stock to fail the team's sense check.
The Hermes European Equities team incorporates ESG aspects as a complement to their analysis and decision making. ESG considerations, therefore, are an important element in the assessment of a stock for inclusion in portfolios but are not a dominant factor. As with our Small and Mid-Cap teams, a positive ESG stance is considered favourable to an investment case, but it is just one of several factors considered when deciding whether or not to make an investment.
For our Global Emerging Markets strategy, the portfolio manager looks to identify a catalyst before investing rather than buying and hoping a catalyst appears. Some of the catalysts the team looks for include improvements in corporate governance / ESG, and improved capital allocation. The team makes use of both a top-down and bottom-up approach, and their top-down analysis led to removing direct exposure to the oil & gas industry, partly informed by their view that long-term climate risks were too high and made the industry generally unattractive. Additionally, because emerging markets are not as transparent as developed markets, the risks are higher and the team recognises that investors need to be more prudent, with a margin of safety. An approach integrated with the analysis of ESG factors gives this margin of safety in the strategy.
Similarly, for our Asia ex Japan fund, assessments of corporate governance factors are particularly important when considering potential investments in certain countries, such as China. The team has a varied and lengthy list of warning signs that they keep in mind, and the team seeks to visit and/or speak directly to management prior to accepting a stock into the portfolio.