The cornerstone of our research process is a risk framework centered around 4 key stock specific risks, against which we assess all prospective and existing investments: Business Risk, Financial Risk, Corporate Governance Risk, Valuation Risk. It is by ensuring that our investments are not excessively exposed to these four risks collectively that we are able to get comfortable with their suitability for our portfolios. Corporate governance in emerging markets has such an explicit bearing on stock price performance that it is a mature and standalone category of analysis in our research process.
After an extensive period of study we concluded that the following three sustainability factors encompass many of the other non-financial factors that can have an equally material impact on core business profitability and long-term investment returns:
The environmental impact of production
The treatment of human labour
We consider these factors components of Business Risk on the basis that they can have a material impact on underlying business profitability from a loss of sales, financial censure or reputation. These factors, and particularly their sub-components, are relevant to companies in varying degrees (e.g. emissions are more of a concern for a chemicals manufacturer than a retail bank) but at least one of these factors is applicable to every company in our universe. We are also able to demonstrate how a deterioration in each of these factors can have a material impact on a company’s profitability and share price performance. We do not expect these factors to encompass all relevant social and environmental issues. We do however think that they provide a more refined framework than the more widely adopted but looser ‘ESG’ perspective.
As components of Business Risk, the environmental impact of production, the treatment of human labour and product responsibility are assessed as part of our core due diligence on companies. Findings are recorded in our initiation notes and in annual updates thereafter. As with any new piece of information, assessing materiality is essential. The team are required to make an explicit assessment of the materiality (low, medium or high) of each of the three sustainability factors when conducting due diligence on a company. If a risk is considered elevated, further information is sought in the same manner as other potential threats to core business profitability. If a sustainability factor is thought to pose an intolerably high threat to core profitability, the company in question would be discarded. For less extreme cases, the sustainability analysis may impact the future rates of growth in demand, operating or capital costs assumed in our financial modelling. A key challenge is designing methods to elicit valuable information from companies beyond their statutory CSR reports or prepared ESG responses. We have developed a bank of questions that are continually field tested and refined by our investment team to help uncover valuable information over boilerplate answers.
Sustainability analysis training, the evolution of our process and the incorporation of ESG principles into our investment activities is overseen by our Partner, Anthony Linehan, with the support of the other senior members of our investment team. However, by design, the learning process is iterative and requires committed contribution from the wider investment team using real world experiences.