Sustainable Investments: A Guide For Young Generations. Article 4 - Three Other Sustainable Investing Strategies
After presenting the first three main strategies that can be embraced by all investors interested in sustainable investments in the last article, let's immediately start by presenting another three strategies that follow the same mindset, although with different applications, and mostly used by investment professionals that are in possession of greater resources.
Impact Investing
Recalled from the second article of this series, impact investing it is defined as “investments made into companies, organizations, and funds with the intention of generating a positive social and environmental impact, alongside a financial return6”. Impact investments provide capital to address the world’s most important challenges in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services including housing, healthcare, and education. Since the inception of the term in 2007 until the recent years, the approach has been accessible almost only by institutional investors and high-net-worth individuals, because these types of investments are very illiquid, representing a major risk for retail investors, and also because of some very specific characteristics that impact investment must fulfill in order to be categorized as so. Data from 2018 showed that assets under management held according to this approach amounted to $444 billion, a 79% growth from 201667. More updated stats saw the amount reach $715 billion in April 2020, another 61% increase from 2018, stating the strong signal that impact investing is a trending strategy, since motivations to create positive impact remain high.
Historically, public entities or philanthropy organizations have played the role of providing the solutions needed to address societal or environmental challenges. Impact investors on the other hand, aim for business models that offer market-based solutions for these challenges. Investors seek for a specific set of characteristics in order to distinguish impact investments from other approaches:
• Intentionality – companies or investment funds that are raising the capital must intend to achieve a positive social or environmental impact as their main purpose.
• Measurability – the investees must set their goals as for what they want to achieve through the project, and then measure the progress towards those goals through pre-defined metrics. The GIIN (Global Impact Investing Network) provides impact investees with standardized impact metrics, in order for them to report back the progress to their capital providers.
• Additionality – the capital provided from investors must be additional to the project, meaning that the project would not have been realized were it not for that particular capital being deployed (e.g. financing a construction company with $x million means to build so many more houses, if the capital is not invested, the additional houses cannot be built)
Because of these three characteristics, the majority of the impact investments takes place in private companies, private debt/equity funds, venture capital funds, and real estate, almost always in the form of primary market investments; in the secondary market, where millions of shares/bonds change hands in a matter of seconds, the characteristics cannot be kept track of, making impact investments quite difficult to become accessible by retail investors.
For the purpose of an example, we’re assuming that we are a high-net-worth individual invited to invest in a private company whose goal is to serve the segment of the India’s population that is unserved from banking services. The company serves the social purpose of the development of an unfavorited market segment, and it plans to raise $20 million. From those investments, they plan to create 50 new jobs and improve 10,000 individuals’ lifes by giving them access to banking services. The proposal for us is to invest $3 million in the deal, with the intention of recovering the full invested capital in three years, alongside a return. Without our capital, the project cannot reach its objectives completely, hence changing plans to either address new potential investors or to reduce its objectives to the level that the current accumulated capital could allow. By analyzing the proposed deal, we can clearly notice that the three requirements are found in it. The project’s intentionality is purely focused in social reasons; its goals are measurable by pre-disclosed metrics; and additionality too is present, since the project will deliver less results if the full capital cannot be raised. The investment proposal gives indications also regarding the economics of the deal, from which can be extracted that the primary objective of the initiative is purely social, while the intention of returning the invested amount and a financial return are second-level priorities. If the project is aligned with our beliefs, we can provide the funding to the company and vice-versa.
With the help of new technologies, impact investing is expected to be accessible also by retail investors in the near future, as long as this strategy will be in high demand from young generations. Since the market is highly unregulated, interested investors would need to be able to perform serious due diligence to filter proposals, or to make sure that they trust the platforms that will offer these kinds of services, in order for their funds to truly reach companies that want to have a positive impact on the planet or in social causes.
Active Ownership: Exercising Voting Rights and Shareholder Engagement
Every shareholder of a publicly listed company has the right to vote in annual general assembly meetings regarding management or shareholder resolutions, to formally express their approval or disapproval on relevant topics such as where the company is directed, executive compensation, annual financial results and more. A sustainable investor sees as fundamentally important the opportunity to express her opinion during these meetings. Although retail investors have relatively less shares than institutional investors, therefore their voting power is smaller, it is still important for them to exercise their voting rights. Exercising voting rights means to foster good corporate governance practices and social responsibility, increasing the company’s chances of long-term success. The notion of voting is strongly linked with another highly important one that retail investors can embrace, known as “shareholder engagement”. Shareholder engagement goes beyond voting and captures any interactions between the investor and the current or potential investee companies, with the aim of influencing a company’s business conduct. Fundamental activity of shareholder engagement is the open dialogue between investors and company’s executives regarding strategic plans and ESG issues. Dialogue and engagement offer investors the opportunity to create added value such as:
• Development of business strategy that is better equipped to deal with long-term challenges
• Reduction of reputational risks
• Maximization of returns
• Contribution towards sustainable development
• Improvement of businesses’ ethical conduct
Combined together, voting rights and shareholder engagement create the strategy known by the industry as Active Ownership, which the Principles for Responsible Investments define as "the use of the rights and position of ownership to influence the activities or behavior of investee companies". In 2018, $10 trillion were held according to the active ownership strategy, representing 30% of total sustainable assets under management, with a CAGR 2016-2018 of 8.3%. Active Ownership is not about voting once a year nor micro-managing companies to the slightest details, but is primarily about open communication between the involved parties, with investors on one side explaining their expectations and opinions and companies on the other one that provide clarifications regarding their vision and practices.
This strategy mostly follows a qualitative approach, and unlike the previous strategies that were discussed, where the investor could be searching for companies to invest and was not already a shareholder, in active ownership the investor must currently be a shareholder in order to exercise her rights and influence the company. The company announces its AGM (annual general meeting) which as indicated by the name takes place once a year. In the same period, it releases also the agenda containing issues regarding various topics that will be discussed in the meeting. Usually, the AGM and the agenda are announced to shareholders in advance, in order to leave them time to prepare questions and suggestions. In the period between the announcement and the date of the AGM, the items on the agenda should be analyzed in detail so a position (in favor/not in favor) can be taken. Since typically investors are in possession of a portfolio that includes more than a company, and the companies sometimes are spread around the globe, analyzing in detail all the agendas and annual reports could be very time-consuming and go beyond the resources that an individual investor is in possession of. Therefore, groups of individual investors may be formed, joining their resources in order to understand the items on the agenda and make informed decisions. Another solution is to hire “proxy advisors”, which are independent companies offering the services of agenda and annual report analysis. Again, individual investors can join their resources to hire proxy advisors as a group, since usually the fees for these types of services are not irrelevant. Investors may use proxy advisors’ recommendations to form their own opinion, or they can delegate their voting power to these agencies, which are then responsible for voting on the AGM. This is a major advantage for investors in the shareholder meetings, since those who are unable to attend the meetings themselves can delegate their voting power to proxy advisors, other shareholders, or legal representatives.
The annual general meeting is a great place for investors to complete their “duties” as active owners of companies, complementing their voting rights with shareholder engagement responsibilities. Except for voting, they have the rights of asking questions and therefore starting a dialogue with company’s executives, but they may also be able to propose resolutions that can be included in the agenda, depending on their ownership in the company. In the USA, 278 ESG related resolutions were added from shareholders to the agendas of the top 250 companies, which then were approved by the majority of the shareholders, despite the opposing position of the boards of directors, while in Europe, there have been cases when also the boards of directors accepted shareholder proposals. Ownership threshold to add a resolution varies across countries (in Switzerland a shareholder must have at least CHF1 million invested in the company in order to propose a resolution, while in the US the threshold is only $2.000), so investors should be informed on their specific country regulatory.
ESG Integration
This strategy is by far the most difficult one to understand by non-ESG practitioners and to be embraced by retail investors, since it requires prior knowledge regarding corporate finance, valuation, and financial modeling, but is indeed important for millennials and gen z’s to at least understand how it works, in case they want to invest in an investment fund that uses this approach for their decisions, or in case they want to try by themselves to arrive at ESG driven valuations. ESG Integration is the strategy that investors use to incorporate ESG factors (described in previous articles) into financial analysis regarding investment opportunities. At the beginning it may sound confusing and/or the same as Negative/Positive Screening, but contrary to these strategies that use ESG data to make the decision of including or excluding certain companies from the investment portfolio, ESG integration blends together traditional factors with ESG ones, in order to arrive at a fair valuation of a company’s share or bond value, informing a buy/sell/hold/don’t invest decision (the example written below will make the understanding of the strategy much easier, hopefully :D). According to the Global Sustainable Investment Alliance, assets under management invested considering this approach amounted to $17,5 trillion in 2018, up 69% from 2016.
Investors start by applying qualitative ESG analysis for their investment decisions, such as scores or ratings provided by third parties (MSCI ratings as an example) and information retrieved from companies’ annual reports. Then, they integrate the qualitative information to arrive at quantitative results. A quick explanation on how industry professionals value companies is needed to be given in order for non-financial background individuals to properly understand this strategy. The most used tool for finding a company’s fair value is the discounted cash flow (DCF), a financial model that attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. Financial analysts usually make estimates for the next three to five years regarding companies’ cash flows, and then, for the following years, they estimate a constant growth rate called “g” with which the company is going to produce the future cash flows. Another important financial concept is needed to be explained to go further, more exactly the time value of money, according to which a dollar today is worth more than a dollar tomorrow, since you can invest the dollar today and tomorrow you will have the initial dollar plus the return (or interest) that you won on the invested amount. The projections that financial analysts’ make are based in the future, so the cash flows that are estimated are worth less than they are worth today, hence they need to be “translated” in today’s terms. This translation in today’s terms is made possible by the discount rate. The constant growth rate “g” and the discount rate, together with company’s revenues and costs, make up the most important input factors for the DCF model, therefore the most important factors that influence the fair value of the company. ESG Integration means taking into consideration the ESG factors when estimating the future revenues, costs, discount rates and growth rates, alongside other factors that impact the DCF model.
Important note: ESG Integration can be applied to every single company whose shares trade in a stock exchange. It is not applied only to companies that are considered sustainable, since its goal is to use the ESG factors only to arrive at fair valuations. The strategy leads to the promotion of companies with high ESG scores and performances, since those companies will be worth more based on the DCF model. On the other hand, companies with poor ESG ratings and performances will be worth even less from after integrating the sustainability factors in the DCF, making them less desirable for the investors.
Through this example we will integrate ESG factors into the valuation of a company that produces computer hardware and operates in the market for more than 20 years. Starting from sector analysis, company’s financial results and other relevant data we can create the financial model that tells us the fair value of the company, without taking ESG characteristics into account. Let’s assume that we found out that the growth rate of the revenues “g” will be 5%, the net margin will be 10% (profit will be 10% of the total revenues) and the discount rate is expected to be 10%. With these inputs, we arrive at a fair value of $50 per share (other assumptions such as revenues etc. were made to arrive at this number, which is presented for explanatory purposes only). Then, consulting ESG data providers and company’s sustainability reports, we identify three characteristics that we think are relevant and can impact the company’s future earnings, hence impacting its valuation:
• The company uses ecological raw materials, bought in suppliers that are considered sustainable from rating providers. This fact may increase its revenues growth rate by an additional 1%, since companies that protect the environment in their supply chain are more appealing to consumers.
• The company pays a lot of attention to its human resources through different initiatives, resulting in a lower employee turnover ratio. Since less employees will leave the company, the costs for on-boarding and training will decrease, resulting in an increase of 1% in the net margin.
• The company shows good leadership skills from their corporate governance team, with transparent remuneration policies and a well-diversified board of directors. This factor reduces strategic risk, therefore reducing also the discount rate by 1%.
With the newly calculated, we arrive at a growth rate of 6%, a net margin ratio of 11%, and a discount rate of 9%, resulting in a fair value per share of $83 (the price is based in the previous assumptions and a simplified version of a DCF calculation that calculates only the terminal value is used). From this example we can see that integrating sustainability factors into financial analysis can result in fair values that are well above/below market estimates, highlighting the importance that these factors can have in investment decisions.
Integrating ESG factors into traditional financial analysis is the most difficult strategy to be followed by retail investors, while at the same time being one of the easiest for institutional investors. The approach has pure financial objectives as its primary goal, but it proves sustainable as it promotes the companies that take sustainability seriously, whilst it discourages investments in non-sustainable firms. Mutual funds and active ETFs that invest through the ESG integration approach are constantly increasing in numbers, giving a lot of choices to retail investors that want to invest sustainability through this approach.
Sustainable Investing Strategies: Final Words
These last two articles presented the six main strategies used by retail and professional investors. A recap of the methodologies is represented by the figure below.
References
“Impact Investing.” The GIIN.
“2018 GLOBAL SUSTAINABLE INVESTMENT REVIEW.” GLOBAL SUSTAINABLE INVESTMENT ALLIANCE, 2018.
“Study Reveals Growing Demand for Impact Investing among Retail Investors.” Wealth Adviser, 28 Apr. 2021.
CFA Society Switzerland, et al. “HANDBOOK ON SUSTAINABLE INVESTMENTS Background Information and Practical Examples for Institutional Asset Owners.” CFA Institute, 2017.
“A PRACTICAL GUIDE TO ACTIVE OWNERSHIP IN LISTED EQUITY.” Principles for Responsible Investment, 2018.
“European SRI Study.” Eurosif, 2014.
Fernando, Jason. “Discounted Cash Flow (DCF).” Investopedia, 13 Mar. 2021.