REABSORBING
ESG
ESG ANALYSIS SHOULD NEVER HAVE BEEN CARVED OFF AS A SEPARATE DISCIPLINE. LITTLE HAS BEEN GAINED FOR THE BACKLASH THE LABEL HAS PROVOKED.
The analysis of ESG risks and opportunities should now be reabsorbed into fundamental research. A successful rescue of this floundering idea could both advance our understanding of value creation and provide rewarding insights into the interplay between the value of an asset and the values of investors.
KEVIN PAUL
Director – Responsible Investment & Equity Strategy
INVESTORS WITH AN EYE ON INTRINSIC VALUE HAVE LONG CONSIDERED CORPORATE CULTURE AND INTANGIBLE ASSETS.
These two broad concepts subsume several indicators typically included under the ESG banner.
Anyone interested in the foundations of value may find it strange to set aside a list of environmental, social and governance factors for separate analysis. After all, these very factors are among those that underpin the numbers in a discounted cash flow model.
Look hard enough for ESG through the intrinsic value lens and it starts to lose definition, not because it lacks substance, but because it is all-pervasive. So casting ESG as a distinct field raises questions about its definition, purpose and potency, leaving it in a veritable identity crisis. Unfortunately, this has left the field open for sworn opponents to build straw men that are easily consumed by the flames of politics and ideology.
While all ESG factors can affect intrinsic value through either cash flows or the cost of capital, not all ESG factors will be equally pertinent to all companies at all times. Their materiality will fluctuate – with a company’s strategy and lifecycle stage, for example. So will the market’s perception of their materiality. Moreover, the ESG factors that matter to an investor may vary with the intended holding period of a particular investment.
AVOIDING GROUPTHINK
All this may be stating the obvious. But these observations lead us to a somewhat controversial position: when it comes to ESG analysis, perhaps we should embrace idiosyncrasy and subjectivity and steer clear of conformity and groupthink. Pushing investors and corporate managers towards box-ticking and standardisation may end up corrupting our collective understanding of the drivers of value creation.
If the goal is transparency to help us better assess corporate culture and intangible assets (as well as the more visible tangible capital), then let’s zoom in on material factors. And, when the landscape shifts, let’s be nimble enough to reorient the lens. Any less concentrated approach, such as a multi-faceted ESG rating, will likely create more noise than signal.
QUESTIONS OF MATERIALITY
What matters most for value creation given the business model in question and what we think we know about the present and the future?
What three levers should we pull to take valuation to the next level?
The answers to these materiality questions will be expressed initially in financial jargon, terms such as organic growth, operating margins and R&D expenditure. Ultimately, however, they will be forced into the extra-financial space, populated by ESG terms like social licence to operate, energy efficiency and employee upskilling. This is inevitable. A couple of layers down, it is all ESG.
This underscores our argument so far. ESG analysis does not need a separate label. Instead, the term should be dissolved and its components should be reabsorbed into fundamental analysis, where they belong. In particular, these headline financial indicators (such as organic growth) should be tracked back to the material factors underpinning them.
DIFFERENT FORMS OF CAPITAL
One useful unifying framework can be found in a multi-capital approach: first identify the company’s key pillars of capital; then evaluate its access to, utilisation of and enhancement of capital; and finally assess the market’s valuation of these pillars of capital (Figure 1).
When we are assessing how a company creates value, this framework encourages us to see capital dependency as key to materiality. We should dig deepest into the pillars of capital the company most relies on to achieve its strategic goals. A well positioned company can readily access the capital it needs at a favourable cost, can use that capital productively today and can enhance it to increase the chances of creating and capturing value in the future. This perspective applies in much the same way across the six types of capital in Figure 1.
Moreover, if we believe efficient capital formation is at the heart of value creation, we should also monitor how well the company converts one form of capital into another. For example, can it transform financial capital into manufactured capital by building factories at low cost thanks to efficient processes? Or human capital into intellectual capital by encouraging employees to contribute their best ideas? These capabilities will likely underpin any sustainable competitive advantage the company enjoys over its peers, especially during times of geopolitical and economic volatility, when uncertainty is laced with scarcity of resources.
NO COMPANY IS AN ISLAND
Two questions – at least – loom large.
First, the practical question: how should we measure and track these capabilities? The answer is partly to blend financial data with what is now called ESG data, from not only individual companies but also the ecosystems in which they operate. This is no mean feat. Even if designed well across the board, these hybrid metrics will more easily yield insights for some types of capital (such as human capital) than others (the more nebulous social capital, for instance).
We will have to save an exposition of this multi-capital dashboard for another time. But suffice to say the dashboard demands both qualitative and quantitative input, as well as a healthy dose of engagement with companies and stakeholders.
Next, the philosophical question: how should we define value creation? Leaning on a traditional, narrow economic value framework, we might roll out some well rehearsed comments on the spread between return on invested capital and cost of financial capital.
However, when armed with the multi-capital framework, we can offer a broader response. For instance, we can distinguish between economic profit that comes with a bundle of nasty externalities (such as dangerous pollution or dwindling resources) and economic profit that neither damages the stock of productive capital nor impairs future operators’ ability to generate similar levels of economic profit.
A WIDER FRAME
This analysis sounds intractable, but in a sense it plays to the strengths of ESG. If we can reframe data on emissions, resource use, the supply chain, patents, employees, customer satisfaction and so on as ecosystem health indicators, we can start grading economic profit streams on their likely persistence, or sustainability. To reiterate: the goal is not to retire ESG but to reabsorb it into the body of fundamental analysis where it can sharpen our understanding of how financial statement outcomes are really generated. And that includes engaging with companies, but without drawing an artificial distinction between ESG and financial factors.
From here we can consider the balance between value creation and value capture, and whether collectivism might be a compelling path to competitive advantage. (With supply chain transparency on the rise, such seemingly esoteric topics may quickly become mainstream.) If we want to understand a company’s long-term prospects, should we look only at the business itself? Or should we adopt a more holistic assessment that pulls stakeholders under the microscope too? This echoes the type of question a universal owner (a large institutional investor with holdings spread broadly across assets and markets) might grapple with when faced with externalities from an individual holding: how should we prevent local optimisation impeding our search for system-wide gains?
VALUE/VALUES
Having raised the topic of externalities, we should offer some brief thoughts on how investors’ values might intersect with the value-centric arguments in this piece.
The more straightforward case is where an investor wishes to express their personal values by avoiding assets associated with certain activities (tobacco, say, or armaments) or by seeking out certain categories of impact (such as green energy). And they do so regardless of the risk premiums offered by the market: the valuation doesn’t matter. The case of an individual investor like this will naturally fall outside the scope of this piece.
More complex cases arise when values start to take hold across broad stakeholder groups. That will have implications for the intrinsic value of an asset, even if the holders of these values aren’t at all thinking about their preferences in terms of value. For one, if values end up shaping capital flows, they can affect companies’ access to and cost of capital. In addition, if values start altering the political landscape, new regulations can erode companies’ revenues and drive up operating costs. These forces can disrupt companies’ investment plans, which in turn can transform the prospects for suppliers and customers. Thus values can produce ripples through the ecosystem that destabilise value in unexpected ways.
SUSTAINABLE VALUE CREATION
Reabsorbing ESG into fundamental research will no doubt add complexity. The extra financial analysis we are advocating will often fail to deliver a precise, quantified conclusion. “Not everything that counts can be counted,” as sociologist William Bruce Cameron put it. Qualitative analysis will be required to plug holes and help us interpret the quantitative data. But, if we can recast ESG analysis as foundational rather than peripheral and if we can embrace the inherent subjectivity, then we can surely jettison the dead-weight definitional baggage and get down to the business of looking for genuine, sustainable value creation. ⬤
“IF VALUES END UP SHAPING CAPITAL FLOWS,
THEY CAN AFFECT COMPANIES' ACCESS TO AND COST OF CAPITAL.”
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