Sustainability investing has been one of the most supercharged trends in global markets over the past two years. Investors need to understand how investment analysis plays a part in the call for sustainability in the markets.
Fundamental analysis helps estimate how much a company is worth in terms of revenues, production, costs, and profits. Value investing establishes the rules that weigh the stock price against the estimated intrinsic value.
But what we know today about fundamental analysis ignores a long-term cost known as externalities in economics. The science showed industrial production that was rising to meet the needs of a growing world population was also generating greenhouse gases that were heating up the planet. This is a long-term cost that ultimately somebody has to pay for but is currently not reflected in the prices we pay as consumers. There is also plastic waste, stress on food production and water supply as well as social costs such as income inequality and health risks posed by excess production and consumption. The impact of industrial production or human activity on the biosphere is already becoming more visible with extreme weather phenomena, droughts, diseases, and threats to food and water supply.
Why should investors care?
Investors will need to factor in these risks on their investments. The movement is not new since many funds, particularly outside the Philippines, have already started to integrate environment, social and governance (ESG) risks into their investment processes. ESG, sustainable, and socially responsible investing belong to the spectrum of investment styles that consider these nonfinancial and material risks into investment decisions.
There are two reasons. Firstly, there is transition risk or the risk of changing trends to integrate sustainability. Whether we like it or not, the global energy markets will start decarbonizing their power grids. It is likely that the private sector will lead the way. It is expected that access to funding and insurance for coal and other fossil fuel-based energy businesses will gradually be affected. Green capital may avoid banks that do not adhere to a sustainable finance framework. The second reason is the risk of the effects of environmental damage on physical assets. As scientists predict, the trend to 1.5° degrees celsius will mean more extreme adverse weather phenomena. While insurance can hedge against the damage, the effects can cascade into other failures. The return of inflation as a threat to real returns is partly linked to the food supply affected by disease. As recent as 2019, Metro Manila was affected by a water supply shortage with growth in urban center demand outstripping the existing capacity.
Where is PH in the global movement?
In our view, ESG and sustainability investing is still in its infancy here but growing rapidly. ATR Asset Management (ATRAM) launched the Sustainable Development and Growth Fund (SDGF), a unit investment trust fund that selects companies based on their integration of the United Nations Sustainable Development Goals (SDGs) into business strategies using a proprietary ratings framework. The first of its kind in the country, the fund has outperformed the Philippine Stock Exchange index (PSEi) by 14.3 percent as of end-October. At the core of the strategy is the analysis of nonfinancial sustainability data disclosed by companies with an overlay of profitability measures and quantitative methods.
Selective bias
The aggregated non-inancial data of companies in our SDGF over the past two years show the effect of the 2020 lockdown. With GDP (gross domestic product) contracting by 9.6 percent, we also saw emissions, energy and water consumption, and waste generation dropping by 11 percent, 12 percent, 24 percent, and 32 percent year-on-year, respectively. The reduction of economic activity in 2020 resulted in less impact on the biosphere and a negative impact on communities and firm profits. The outlook on the planet, people and profits are intertwined.
There are three key insights of ATRAM’s sustainability research. Firstly, there is an implied correlation between research and development, innovation expenditure, and employment growth with returns. Unfortunately, most local companies spend less than 1 percent of revenues on innovation. Those who do, tend to have faster growth.
‘Good’ versus ‘bad’
The second point is that image is not necessarily in sync with the data. Some may call this a form of greenwashing but we consider this a tendency for selective bias. We do not believe this is intentional but an offshoot of the preference to report “what we have done” instead of emphasizing “what still needs to be done.” That said, investors may not see the extent to which the cost of these externalities is being integrated into the business. Investors need to be cognizant of this natural bias.
The third is values-alignment versus impact. There are clearly some nonnegotiables for investors e.g., impact to health such as lifestyles that promote cancer and disease, criminal activities, and harm to others. However, some investors may label businesses as “bad” e.g., carbon-emitting or “good” e.g., low/zero carbon and focus on exclusion to maintain consistency with their values.
For funds that prefer to have an impact on carbon footprint, waste, food supply etc., investors will have to understand the need for engagement with both the “goods” and the “bads.” There are trade-offs and the desired impact of integration may take time depending on the speed and urgency of transition.
Sustainability is not just a one-off thing but needs constant monitoring, intervention, and adjustments. SDGF’s focus is integration, impact, and returns. In the future, ESG strategies may be focused on values-alignment and returns.
With the emergence of sustainable investing, the value in value investing is no longer just a number but also a vote of confidence, appreciation, or even gratitude by the community. INQ