Responsible Investing – ESG – much more to it than simply “Do No Evil”

Andrew Canter, chief investment officer of Futuregrowth, shares all you’ve ever wanted to know about the fast growing concept of Responsible Investing (or ESG – Environment; Social; Governance). And it’s more complex than just avoiding short-term decisions or obviously errant corporations. In this wide ranging discussion Canter offers his views on many related issues, including some specific thoughts on coal fired power plants through to Google; and from Sasol to British American Tobacco. – AH

ALEC HOGG: Andrew Canter, back from an extended period with a happy time. Andrew, your baby boy has arrived and all is well?

ANDREW CANTER: Indeed, everything’s going really well and my colleagues were exceedingly generous in giving me some paternity leave.

ALEC HOGG: We’re delighted that you’re back as well because the engagements that we’ve had over the past few months have been fascinating. Today we’re going to tackle something that’s not too well understood – Responsible Investing – which, in essence, is at the core of what you do at Futuregrowth.

ANDREW CANTER: Indeed. Our view is that it ought to be at the core of what all investors do and to some extent, it is. When you’re looking after people’s money, by definition you are supposed to be acting in a responsible way. I guess the new terminology is focusing beyond just financial analysis or a company’s strategic analysis to think about how companies govern themselves, what their impacts are on the societies and the communities around them, and how they impact the world.

ALEC HOGG: We had a very interesting discussion on CNBC Africa Power Lunch today with a member of the Black Business Council who, in essence, said that he didn’t like the proposed change in the PPC Board of Directors there because it was racist – more whites were coming onto the Board than blacks. I guess one’s going to see these kinds of governance issues settling down in time to come.

ANDREW CANTER: Well, that’s an ongoing debate. When we talk about how we assess companies on their governance scores – how they govern themselves and how their Boards are composed and structure – there are no hard and fast rules. There are some companies which, clearly, ought to have wide racial representation on their Board. Some companies may be in a business that has a ‘one colour’ Board, albeit black or white, depending on who their constituencies are, who their customers are, and whom they’re serving. There is no clear answer to how a Board ought to be structured. It depends on the business and that’s part of the fluidity of being responsible investors – being able to assess that in the context of the company you’re analysing.

ALEC HOGG: Very complex….

ANDREW CANTER: Well, it’s not that complex. You can generally identify where conflicts exist, where a Chief Executive has too much power, can set his own pay, and make payments to third parties without any oversight or governance. You can generally see when a company has a weak audit committee. They can’t really assess the financial accounts, and they can be bulldogged by management. That’s the kind of thing that you’re really looking for – checks, balances, oversight and approval processes.

ALEC HOGG: Perhaps the most famous company that’s trying to be responsible in itself is Google with its credo of ‘Do No Evil’. Is that the way that you would anticipate other businesses would evolve in time?

ANDREW CANTER: It’s a hard question because again Google has its own set of stuff with all the privacy questions that we all ask about. Because they say ‘Do No Evil’ and yet, we become the product which is sold to some third party. So that’s a very difficult thing to assess from a sustainability point of view. We, as consumers, won’t tolerate a breach trust by a big company like a Google or a Facebook; it would be easy to abandon them ‘en masse’ because they have no hold on us, really. That’s a business restraint. So from that point of view we have to think about ESG (environmental, social, or governance) screening. The social forces there could be enormous on a company like that. They could lose their entire business in a short period if they do the wrong thing with the data they have. If you look at another company like African Bank, it’s much closer to home but really, a great example on the matter of sustainability: impoverishing your own customers is not a sustainable business strategy and those chickens came home to roost. Again, ESG screening would have shown that up. It would have shown that the consumer can’t afford to pay back what he’s borrowing. Therefore, the company didn’t have a sustainable business strategy and therefore, it was an investment to be avoided.

ALEC HOGG: Just unpack ESG. Environmental, Social, and Governance – they’re three words that are now going to become increasingly important particularly for public companies.

ANDREW CANTER: Right. We’ve talked about governance. What we, as investors and the public, really want to see in the governance of companies to make sure that they operate in a suitable manner with suitable checks and balances. When we think about environmental factors, we would think about whether a company is polluting the environment. That’s not just a warm and fuzzy ‘let’s protect the trees’ approach. Rather, it’s saying that if you’re creating environmental degradation, it’s pretty darn likely that at some point the government’s going to come after you for some back taxes, penalties, or fines that damage your business.

Therefore, as a shareholder, part of your assessment has to be are there environmental risks in the business I’m investing in that could come back and cause a degradation of my value.

Alternatively, on the positive side, you may have a company that’s recycling tyres and it’s doing a positive thing for the environment by reducing the tyre mountain and turning it into some useful product. That’s a positive environmental screening. All of these things are two-edged swords. You could also find companies that are really well governed, that you want to invest in because you believe that the Board is operating at a very high level of strategy thinking with trust and healthy culture, that that makes a good company better and therefore, becomes a good investment. As we look at each of the factors and we think about the broader sweep of analysing companies beyond financial, there’s a whole range of factors that should help us decide whether it’s a good investment or a risky investment.

ALEC HOGG: Can you put weightings on them yet, relative to the financial undertone?

ANDREW CANTER: That’s a great question because the natural starting point for analysts like us when we start to do this sort of stuff is to make lists, make checklists, and put weightings on them. The truth of the matter, though… What I’ve found is that you can’t. It’s very company-specific. The environmental factors of an oil company are completely different from the environmental factors of a retailer. You could make a list, but the two lists are going to be widely different. I think you really have to look at each business on its own merits and its own factors. You determine the top four or five issues that affect governance, the top four or five issues that affect labour relations and social screening, the top four or five issues that affect the environmental impact, and you do that company by company. It’s very hard to come up with an overall checklist and a standard weighting scale.

ALEC HOGG: I was talking to a friend today and the question came up of tobacco companies. BAT is a core holding in many South African portfolios. It would be hard though, on environmental, social, or even the governance side, to justify those kinds of investments. How do you look at that one?

ANDREW CANTER: That just proves the point that there is no standard measure of what is ‘good’ or ‘bad’ in the world. If you’re a smoker then BAT is a wonderful investment and you understand what they do. If you’re a non-smoker, you think that they’re selling the devil’s product and killing people in slow degrees. This stuff can be very judgmental and indeed, you can have an extraordinarily well managed company that has really great social interaction with its employees and the community around it, maybe through charity programs or how it treats its staff and its unions. And yet it could be selling a product that’s inherently bad. You have to look at all those things but ultimately, an investment – at the bottom line and underneath all that – which probably most asset managers get to is the cash flow businesses. It’s usually cash generative businesses. It’s profitable. It’s long-lived. It’s predictable cash flow streams so it’s not volatile and so they probably look past the negative social connotations of the actual product, toward the underlying cash flows.

What I think should happen, as more investors should tune into the broader impact of sustainability business is that they should have a higher cost of capital for a company like that so if you’re selling tobacco, your PE ratio should be lower than if you’re selling fruit juice, for example.

ALEC HOGG: To look on a broader and more controversial scale, for years now the world has had oil prices of over $100 per barrel. We’ve been paying up for this precious commodity and certain very small groups – relatively speaking – have been benefitting. Of course, it’s all reversing now, but would you look at that as well as from ESG perspective, that perhaps one should stay away or should have stayed away from oil companies?

ANDREW CANTER: Well, that’s a hard one because we all drive in cars and in the northern hemisphere you want to burn heating oil to heat your homes in the winter. If we want to run an industrial economy, we need fuel. I guess you have to start taking an inter-generational view. We’ve been having a really, interesting debate recently about coal-fired power plants. South Africa has a lot of coal. Coal-fired plants are much more efficient to build than say, nuclear and even more efficient to build than say, some of your newer technologies like wind and solar. Yet coal is a very dirty thing. It produces huge carbon emissions. The mining process is dirty. Miners get sick and die.

We have a debate about whether coal is socially positive because it’s power for the economy, or whether it’s socially negative because of all the negative connotations of coal.

We haven’t come to a clear conclusion but we’ve taken a 30-year view that right now, we do need the power because otherwise the lights are going out (and that’s a disaster). However, on the 30-year view, we expect to be able to fund businesses and have alternative sources of energy, whether it’s gas in Namibia or Mozambique, or whether it’s some of the alternative energy schemes where we’ll use an awful lot of money to get those up to scale.

ALEC HOGG: All right. Well, have a look then at another specific – Sasol – where there is a view which I saw an analyst’s report this week, that said Sasol has not yet accounted for its environmental liability – or potential environmental liability – down the road.

ANDREW CANTER: Sasol is a special case and that’s the whole story, isn’t it? Every single company is a special case. Here however, you probably have the single largest carbon emitting enterprise in the country (and I think, in much of the world) from one location emitting carbon. Yet, to turn coal into liquid fuel is an incredibly powerful and competitive technology and not an unnecessary technology, and the world’s finally catching up with that, with fracking. Again, it’s a debate. Do you believe that we, the nation, need hard currency earnings, import replacement, and job creation using a good technology, or do you believe that carbon emissions are the dominant negative force and you should avoid that investment? Remember, the markets are made up of people with different opinions and in a market where you weight the good and the bad, the cost to capital should be the swing factor. They should have a higher cost of equity capital through a lower PE ratio and a higher required return on equity.

ALEC HOGG: The whole thing is a very complex subject.

ANDREW CANTER: It’s usually full of judgment. There’s judgment on all of this stuff.

ALEC HOGG: Yes, and it’s subjective. You could probably, depending on where you wake up in the morning, argue for or against investing in a particular stock. Are there any hard and fast guidelines that you work from?

ANDREW CANTER: Well, sure. There are several ticks which you’ll use on any given company. A good governance score for us is we watch the turnover of non-executive directors – independent directors. If you find that there’s a fairly high turnover of those directors, that’s a pretty good warning sign that something’s up with the governance of that business because people aren’t finding their way clear to stay there. They don’t believe it’s being run strategically well or there’s some other conflict in the boardroom. That would particularly apply if you saw a turnover in audit committees where it starts becoming much more worrying. Those are standard heuristics. You generally want to separate the Chief Executive from the Chairman of businesses. That’s rather a standard rule. Obviously, any regulatory breach is just not even negotiable.

Companies that are going to breach regulation, whether it’s environmental, sectorial, or the financial sector for example, regulation is just a no-go area.

That’s a big red flag that just tells you the company isn’t operating at the level that you expect in a modern company. Companies that have huge and public labour spats that are irreconcilable and unresolvable are clearly sending you a message that their labour relations and corporate structure isn’t sufficient for where they’re living in the society. These are some fairly easy things to spot. But other than that, there’s always subjectivity about whether you’re a smoker and/or a driver, or not.

ALEC HOGG: And as you did spot at African Bank, articulated right at the beginning of this discussion, if you are going to profit at the misery of your customers then clearly, it’s not a long-term, sustainable idea.

ANDREW CANTER: Which isn’t to say that all lending to consumers is bad. Clearly, it’s not. People need lending to buy houses, for their children’s education, sometimes working capital needs, and small businesses need capital. Personal lending is not inherently a bad thing. Rather, it’s the way it’s done – you’re stuffing the consumer with debt like a Thanksgiving turkey knowing that he’ll never really, be able to pay you back and he’s going to be impoverished. I really think that’s where the likes of African Bank and others probably went a bit too far.

ALEC HOGG: Andrew Canter is the Chief Investment Officer at Futuregrowth.