Identifying and understanding the key drivers of risk and return is a crucial skill for any long-term active investor. Traditionally these items were defined purely in economic terms (revenue, margins, volatility of returns etc). However, as markets have evolved, it’s become more evident to some participants that Environmental, Social and Governance (ESG) issues are central to understanding and framing the contextual, systematic and idiosyncratic considerations in investment analysis.

Why Worry about ESG?

Being able to differentiate between short-term issues that arise through the general course of business and systemic ESG issues that will inevitably permeate through the organisation over the long term is a critical skill.

News media play a pivotal role in the ESG space, bringing to light a number of ESG-related issues, particularly when stakeholders experience substantial losses or experience hardship through breaches of corporate governance.

While ESG analysis is often framed as moral values versus economic value, investments motivated purely by moral values may overlook companies that are helping to drive broader societal change.

For investors who focus solely on economic returns, ESG should remain a core component of financial analysis and modelling. As sustainability has permeated the minds of consumers, ESG-related impacts and activities are having a real impact upon the financial performance of companies.

Today, companies are being held to a higher standard and the hurdles to maintain a social licence to operate are only going to increase. Consider poor environmental practices leading to boycott of products, or poor labour relations leading to workforce strikes.

Finding the right balance between these two ideologies can provide for long-term wealth maximization while remaining true to core beliefs. This will enable you to sleep well knowing your investments will deliver sustainable returns through time.

No Defined Rules

There are no hard and fast rules when dealing with ESG issues. Exclusion or divestment based on ESG grounds when your investment philosophy and corporate values are in alignment is sound investment practice. However, when imposing ethical values that are not in alignment with one’s investment philosophy, short-termism may creep in.

We exclude a number of industries including (but not limited to) weapons, tobacco, and gambling. Our investment philosophy and corporate values steer us away from companies that have the potential to harm society, and moreover, help us avoid companies where there is a risk to the sustainability of their business operations.

Companies that act without any consideration for a broad range of stakeholders are met with severe consequences; however, in practice, it is rarely this simple. Issues of such magnitude need to be considered carefully and holistically.

When assessing investments, it is important not to single out one stakeholder as more important than another — this is a fine balancing act for any investor. Understanding ESG-issues, whether historical or current, needs to be understood as interrelated and interdependent to the broader investment thesis.

Some companies who may have a chequered past cannot remain cancelled forever. Companies that engage and act to continue to improve their commitments to all stakeholders can be the types of quality companies that investors should praise.

Consider James Hardie Industries (ASX: JHX), which is a prime example of a company that fell foul to ESG-issues (their ongoing asbestos liability), however, through time their commitment to engage and act on this issue has shown their commitment to all stakeholders while remaining a vital source of support through ongoing remediation.

A More Holistic Approach

ECP is committed to responsible investment and we believe that ESG factors have a material impact on long-term investment outcomes. The consideration of ESG factors is part of our decision-making process and is fully integrated through asset selection and portfolio management procedures.

The ‘Pillars of a Quality Franchise’ is an integrated framework developed in-house to better mitigate our portfolio against ESG and sustainability risks. Our process places a material emphasis on sustainability and stewardship of companies.

Our Sustainability Pillar encompasses three characteristics: Firstly, the business must operate in an industry with a low risk of macro-environmental factors affecting future operating performance. Secondly, the business has demonstrated strong ESG practices and holds a capacity to mitigate potential ESG issues. Lastly, the business holds Dynamic Capabilities that sustainably renews its competitive advantage through time.

By incorporating a forward-looking, scenario analysis of ESG-related affairs, we are able to better understand the risks and opportunities that lie ahead for any company, and more importantly, we assess the potential risk to the predictability of their business operations.

When assessing the business’s ESG track record, we are able to measure and assess the current performance of the business in its entirety and gain conviction that in the event that ESG issues arise, management is able and willing to address these.

Moreover, a key element of our sustainable investment analysis is identifying how a company sustainably renews its competitive advantage through time. Competitive analysis provides us conviction in our investment thesis, however, we need to identify companies that renew, extend, or create resources that continue to drive their competitive advantage.

Quality Franchises & Sustainability

To illustrate, we highlight three of our portfolio companies: Rio Tinto (ASX: RIO), Costa Group (ASX: CGC), and Domino’s Pizza (ASX: DMP). Each of these companies has had varying degrees of ESG-related impacts, and have all managed their issues while continuing to grow their economic footprint.

Quality Mining

Last year Rio Tinto was responsible for the destruction of two ancient and sacred rock shelters in the Pilbara region of Western Australia, the Juukan Gorge caves. What appeared to be a breach of their social licence to operate, with the resulting social and environmental issues driving considerable social outrage, was rather an issue regarding their governance.

The termination of key executives following the disaster was the most prudent step towards managing the cultural change required in ensuring these gross systemic failures are changed for the better.

We highlight that prior to the cave destruction, Rio Tinto was praised for its attempts to embrace Indigenous land rights and was rated the top mining company in Corporate Human Rights for two years running in 2018 and 2019.

Unfortunately, the events surrounding the Juukan Gorge caves have left a sour taste for any investor. It is a prime example of how reputation may take a lifetime to build but can be lost in a minute.

Major disasters such as the Juukan Gorge caves cannot go without punishment. What this looks like is outside the reach of this article, however, looking at management’s response (internally and externally), it would seem the company is moving in the right direction.

The Juukan Gorge matter has been a major disaster for the company. The result though is a renewed focus on all stakeholders and an evolving governance structure that better serves the sustainability of their business operations.

Quality Agriculture

Costa operates in the agriculture industry that carries a number of issues predominantly in environmental sustainability and dealing with the long term implications of climate change.

When we delve deeper into Costa’s business model we find that it has been designed to mitigate the effects of climate change through operating in categories that can be improved through protected cropping, varietal improvement, technology and geographic diversity.

Costa utilises various best practices that are key to improving its impact on the environment but also to ensure it has a much higher degree of resilience in withstanding these factors and promoting better practices that are required in order to lift industry standards.

Costa is immensely focused on its water use efficiency and security as it is crucial to not only gain efficiencies in its application to crops but also to improve yield relative to usage. Costa’s technology improves water monitoring and provides better insight into the variability of water use.

Costa’s berry operations show a 5% reduction in water use as well as a 5% improvement in yield through the use of microclimate sensors. Costa’s latest tomato glasshouse has a closed water cycle and does not require any water sourced externally to the immediate site, which results in a far greater water efficiency than field grown.

Other notable points are their commitment to biodiversity (partnering with the University of England), sustainable energy focus (installed solar farm in South Australia), and fresh produce packaging (using recyclable PET packaging, with 80% being recycled).

While Costa operates in a more carbon and water-intensive industry, identifying which are the highest quality franchises will help investors mitigate against ESG-related risks, and furthermore, help drive our society toward more sustainable and environmentally friendly practices.

Quality Fast Food

Over the years Dominos have had their fair share of media-related campaigns surrounding their franchisee network (labour relations, driver safety), food quality (health), and environmental impacts (cars and cardboard).

With each of these issues, investors negatively viewed the company (in the short-term). However, understanding a broader view of their sustainability as an organisation can demonstrate the true strength of their ESG and sustainability practices, particularly in the context of their ability to drive their competitive advantage and continue to expand their economic footprint.

Some initiatives Dominos have delivered over this years include healthier ingredients (removing salt, colourings and preservatives), shifting to e-bikes as opposed to cars (cheaper to run, better of the environment, quicker delivery), reconfiguring pizza boxes (saving 265 tonnes of paper annually), and zero-touch delivery (safety and consumer satisfaction through COVID).

Notably, Dominos have further demonstrated that they take their ESG responsibilities seriously, with the most recent hire being their Chief ESG Officer, Marika Stegmeijer.

Domino’s is a prime example of demonstrating that sustainable business is good business. Their continual pursuit to improve their offering not only drives more sustainable practices but drives consumer engagement, delivers financial benefits through optimisation, and enables hotter, fresher pizza.

Sustainable Business is Good Business

ESG and short-term investing do not work well together. Short-termism in financial markets drives investors to focus on short-term issues and a clear lack of attention towards longer-term value creation.

ESG issues are highly relevant to a better understanding of the long-term potential of an investment and its predictability of returns through time.

Divesting or excluding companies based on exposure to certain industries without a holistic understanding of the business will do little to ensure our financial system works to more sustainable solutions.

Our societal goals and expectations of a sustainable future are dependent on high-quality businesses driving better industry operations and procedures. It is the Quality Franchises that will deliver more sustainable and environmentally friendly business practices.

When we consider mining companies, excluding these companies under the veil of ESG may in fact do the opposite of what many of us are seeking in terms of sustainable business models. Finding the most exceptional businesses is how we support and drive real change.

ESG and sustainability are interconnected with all elements of a business (strategy, products, its lifecycle, etc). A company that suffers from an ESG-related issue may in turn pivot and adapt to become best of breed, driving greater change benefitting us all. Understanding these nuances is vital for sustainable returns.

Any investor seeking to incorporate ESG into their decision-making process must ensure they don’t fall foul of being swept up in short-term sentiment or virtue signalling at the expense of driving long term positive ESG change. Incorporating sustainability into one’s decision-making will ultimately lead to superior investment returns.

The article has been prepared by ECP Asset Management Pty Ltd (ECP). ECP is a funds management firm based in Sydney, Australia. For further information, visit www.ecpam.com. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial advice. ECP and the analyst own shares in James Hardie Industries Plc, Rio Tinto Limited, Costa Group Holdings Ltd, and Dominos Pizza Enterprises Ltd. ABN 26 158 827 582, AFSL 421704, CAR 44198.