As long-term investors, we understandably care about the quality of our investments now. But it is the future direction of these companies where we can realise the most substantial growth prospects.
Our approach to investing hinges on four main pillars: business quality, management quality, a strong balance sheet and a fair valuation.
Each of these components provide insights into the future trajectory of a company, removing the noise of headline claims.
We prefer to see a large proportion of management compensation based on a variety of long-term metrics such as organic growth, margins, cash flow and return on invested capital, rather than measures such as ”adjusted” EPS, which can be more easily manipulated in the short term.
We can see that many of these factors are becoming inseparable from ESG considerations, as companies realise the responsibility they have to care for the planet and its people.
In this wire, I discuss how we approach finding long term winners, the rise of ESG in mainstream investing and overarchingly the additional information that can be revealed when ESG screens are embedded into an investment process.
Growth in ESG awareness
ESG awareness among investors continues to increase on a global scale. This has been made most evident via the growing prominence of the United Nations Principles for Responsible Investment (PRI) among institutional investors.
Launched in 2006, the PRI was initially established to raise awareness of Environmental, Social and Governance (ESG) considerations among the investment community, as part of developing a more sustainable financial system.
Since that time the PRI has become the world’s leading proponent of responsible investment and as of 2020 exceeded 3,000 signatories and represented over US$100 trillion of assets under management.
Alignment with our investment process
With a central focus on sustainable long-term company performance, the Claremont Global Fund is now a signatory to the PRI. Whilst a new and welcome development, in reality we expect there will be little change to our proven investment process.
Our underlying strategy and our rigorous research-backed process naturally lead to investment in well-run businesses with strong management teams and a culture attuned to the long term needs of all stakeholders.
Since the inception of the strategy in 2011, our goal has been to generate returns of 8-12 per cent per annum, through the cycle, for our investors. We have always stressed to clients the importance of keeping a long-term perspective.
Our ability to achieve this requires us to remain true to our investment process and invest in sustainable businesses – something we believe is largely unachievable, without serious consideration of ESG principles. Research has shown that when companies adopt good ESG policy it’s a positive for all stakeholders, which includes improving financial performance for investors.
Relationship to our investment pillars
Our philosophy and process are based on four key investment pillars:
ESG considerations comprise an important part of our research on the first three pillars when we analyse a company to determine its investment suitability.
Management quality and ESG
We believe that a first-class ESG approach is unlikely to have a tick-the-box methodology. Rather, it is driven by the principles, values and, most importantly, actions that underpin company culture. This flows from the actions of management and the board of directors – with management quality one of the fund’s key investment pillars, (or in ESG parlance, a focus on good governance).
This requires a long-term mindset; a focus on delivering value to customers; equitable treatment of employees and communities; and continuous operational improvement that benefits all stakeholders.
Our experience is that this long-term mindset is typically found within stable, well-tenured management teams – it is unlikely to be built overnight – and is something we seek in all the companies we invest in.
However, culture is more difficult to measure and requires some judgment on our behalf.
With a relatively finite universe of companies that meet our quality investment criteria, we can consistently engage with management teams, allowing us to better assess management’s mentality and actions, and gain deeper insight into the prevailing culture. Prior to investing in a company, we will always speak with ex-employees, competitors and industry experts where possible.
We also look at the composition of the executive team and board, tenure and strategy. This, we believe, allows us to pass both an independent and educated judgement on a key facet of a business that cannot be screened for, lifted from a broker report, or extracted from an ESG score from one of the rating agencies.
Capital structure and ESG
A strong balance sheet – another of our key investment criteria – is often illustrative of good governance, and is an area frequently overlooked, due to a focus on maximising short-term profitability.
Companies that engage in ‘financial engineering’, such as taking on excessive debt to reward shareholders in the short-term, through share buybacks and poor M&A – only to then go seeking government and/or shareholder assistance in times of crisis – is in our eyes a complete governance failure.
Our process deliberately aims to keep us clear of such businesses and industries, allowing us to research and ultimately invest in businesses that are managed to successfully navigate, and indeed prosper, through adverse economic events.
The average age of the companies in our portfolio is currently over 80 years and these businesses have seen many economic cycles and stood the test of time. Their durability is a combination of tested business models; the value proposition they offer their customers and employees; and prudently managed balance sheets.
It is difficult to overstate the power of incentives and we always analyse management compensation closely.
We engage with our companies regularly (at least quarterly), highlighting what we believe are important considerations, as well as voting on the remuneration of executives on an annual basis.
Incentives for some companies are skewed to short-term financial metrics (such as “adjusted EPS”) and a misaligned remuneration structure may lead to short-term gains, but result in perverse outcomes both for the broader community and ultimately for the longer-term shareholder.
When considering the Environmental impact of a business, we find that management teams with a strong culture and good ethics, coupled with the right incentives, are comfortable investing in areas such as energy and water efficiency, waste reduction, and/or proper remediation of historical environmental issues.
These investments can often have a negative impact on short-term profitability but deliver long-term benefits, ranging from reduced carbon emissions, employee safety, favourable reception by local communities, regulators, and customers – all while reducing operating costs over time.
As a result, we prefer to see a large proportion of management compensation based on a variety of long-term metrics such as organic growth, margins, cash flow and return on invested capital, rather than measures such as ”adjusted” EPS, which can be more easily manipulated in the short term.
Business quality and ESG
Of course, a definition of business quality is broader than simple financial metrics.
In the past, Social issues may have been limited to the human resources division, however, today they expand far beyond this narrow remit.
For us, social considerations cover the relationships the company has within its ecosystem. From the impact the company’s products/services have on communities, to the treatment of their employees, places of manufacturing and suppliers. We have no doubt that failure to adequately respect all subsegments of a company’s value chain will impair the long-term sustainability of a business.
Globalisation, transparency, investor awareness and ESG are increasingly (and rightfully) calling into question how a company’s profits are made. We routinely engage with management to better understand whether they may be
compromising on the quality of their product/service (for example, buying materials from a cheaper source that does not adhere to local emission or labour practises) to simply meet a short-term financial objective.
We believe such actions are not sustainable over the long-term but also highlight management’s failure to seriously consider the impact of their business on society and the culture of the organisation.
Identifying quality growth businesses for the long-term
Despite the best intentions, the rise of ESG within the investment community has not been spared the hype that generally accompanies an emerging area of interest where financial gain is possible.
Increasingly, the industry is looking to capitalise on the trend, launching “green” funds (which often come with higher fees), while investors have looked to profit from the share price appreciation of companies they think will be beneficiaries of ESG- focused buying.
With a clear focus on capital preservation, investors in our fund can take comfort that we will remain disciplined when it comes to the price we pay for businesses and exercise caution by avoiding areas of speculation and thematic investing.
As illustrated, the principles of ESG have been – and will continue to be – critical to our investment process and our portfolio of companies.
However, ESG factors are nuanced and typically cannot be reduced to specific metrics or rules that are comparable across businesses. As a result, we believe it is prudent to use independent judgement and consider each business on a case-by-case basis, rather than be governed wholly by externally generated ESG metrics.
To conclude, whilst ESG in the mainstream is a relatively new phenomenon, our investment process has always emphasised management teams with a strong commitment to their customers, employees, communities and wider society. We believe when these factors are combined with good governance and prudent balance sheets, the end result is better risk-adjusted outcomes for long-term shareholders like ourselves.