The Neuberger Berman Sustainable Equity team’s belief that responsibility is a hallmark of quality underlies an investment process integrating business, financial, investment and ESG considerations. Historically, companies that care about building sustainable businesses and good corporate citizenship have generally done better than those that don’t1.
ESG issues can serve as a source of both opportunity and risk control in the long-term. Hence, as analysts, our role, as part of our research process, is to uncover and identify ESG issues that we believe may be a source of risk for the business model of the company and/or an enabler or driver of its secular growth.
But why so? How can ESG issues drive long-term sustainability and financial performance? Let’s take a deeper look.
Opportunities
Example 1: Energy efficiency drives long-term secular growth for a semi-conductor manufacturer
A global leader in analog semi-conductors and embedded processors has a growing market share with economies of scale in world class manufacturing. The companies’ products provide semi-conductor solutions that significantly reduce energy consumption. For example, using one of its semi-conductors to convert fixed-speed electric motors to variable-speed can reduce power consumption by up to 40%. This can be applied in a wide range of applications across a myriad of industries. If all electric motors were converted to variable speed it could reduce US energy consumption by almost 2% and save consumers ~$7 billion. In lighting, the company’s chips can be a key component to LED bulbs. If all U.S. homes switched to energy efficient LED bulbs, it could reduce U.S. power consumption by 3% and save consumers $11 billion. We believe the company should see long-term growth, given that roughly two-thirds of all energy is lost in the conversion and distribution process and with the expectation that the world’s energy demand is expected to double by 20502.
Example 2: Access to healthcare provides competitive moat for a pharma company
One of the world’s largest biotech pharmaceutical companies is focused on improving patient lives through innovative medicines and diagnostics. The company has over 26.5 million patients receiving the top 25 medicines manufactured by the company and 127 million patients receiving off-patent therapies, demonstrating the lasting impact on society in serving health outcomes. Most recently, despite some of the supply and logistics challenges due to COVID-19, the company continued to deliver life-saving medicines to patients around the world, given its resilient global network. The company is also accelerating manufacturing capacity of critical medicines to increase supply globally, and is providing testing solutions to detect the novel virus that causes COVID-19.
Example 3: Product quality and focus on sustainability strengthens global consumer brand
A global consumer products company that markets food, detergents, fragrances, personal care and other products to consumers has a Sustainable Living Plan in place which purports to focus on health and well-being, the environment and enhancing the livelihoods of consumers in developing countries facing sustainability challenges such as deforestation and water scarcity. The company seeks to integrate social and environmental considerations into its product development and its management has goals in place to have 100% of plastic packaging reusable, recyclable or compostable by 2025 and source 100% of all agricultural raw materials by 2020. A focus on product quality and sustainability in turn strengthens the company’s global brand and supports sustained consumer demand which we believe in turn should support business success.
Risk Mitigation
Example 1: Focus on safety minimizes operational risk
A railroad company providing freight transportation across its network in the eastern United States has transitioned to the Precision Scheduled Railroading (PSR) operating model that has enabled the company to increase its operating margin, free cash flow and return on invested capital (ROIC) profile by improving the safety and operating efficiency of its network. With its focus on safety and fuel efficiency, the company is approximately 10% more efficient than its closest competitor, and an industry leader in personal injury safety3.
Example 2: Focus on diversity has the potential to drive talent retention
A best-in-class underwriter and market share leader in auto insurance is a leader in diversity and inclusion. It’s the only Fortune 500 company with female CEO and female Chairman of the Board; has diversity councils in place with executive management team oversight and is recognized for job creation, empowerment, best places to work for women, LGBT and military vets4. This focus on diversity supports longer staff tenure, leading to more experienced and adept staff who are better able to provide industry-leading customer service. It further lowers staff turnover, reducing recruitment and training costs and allowing greater capacity to reward existing staff. For instance, the CEO of the company started out as a claims assessor and grew through the ranks over time to eventually lead the company. In our view, this open and inclusive culture further supports alignment with differentiated brand identity, reinforcing value proposition to contemporary purchase decision makers.
Example 3: Strong environmental practices minimize risk of liabilities
A natural gas exploration and production company has a demonstrated record of being thoughtful, methodical and efficient in its operations. The company operates with high global environmental health and safety policies across all of its geographies. Executive and operational compensation is tied to the achievement of both returns on capital and health and safety goals with oversight from the Board of Directors. This strong focus on environmental policies and practices can minimize risks of liabilities. For instance, poor operating practices could result in regulator fines and even potentially losing the right to operate in certain communities.
Time horizon matters
We believe an important consideration when evaluating sustainability issues is the investment time horizon. Some of these issues may not matter or manifest in the short term, but as the time horizon draws out, the risk of sustainability issues manifesting increases.
Our view is that there is too much short-termism in capital markets today, often chasing near-term top-line growth, instead of focusing on strong fundamentals and sustainable businesses.
As long-term investors seeking to evaluate the growth and profitability of a business over a 3-5-year investment time horizon, it becomes critical to focus on how environmental, social, governance issues could impact the long-term performance of a company.
Some commonly asked questions:
Is one company “more ESG” than other companies?
There is no one size fits-all when it comes to ESG analysis, just like there is no one size fits all when it comes to a fundamental analysis of a company. ESG analysis, in our view, needs to be integrated in the bottom up evaluation of a company’s business model, business mix, the industry it operates in as well as management’s level of focus and integration of ESG issues into the business strategy. The analysis of ESG issues is unique to the company.
Are companies who focus on ESG better companies?
In general, our philosophy is that companies and managements that are aware of and manage the key risks and opportunities relevant to their business, including environmental impacts, workplace practices, supply chain integrity, product quality, governance practices etc. are better investments in the longer-term than those that are not. What gets measured, gets managed. We highly encourage companies who do focus on ESG issues to disclose their practices and any available metrics.
With more ESG data available, is it easier to assess companies on ESG issues?
With the increasing amount of data available on ESG issues, from specialty data providers to industry resources to evolving big data capabilities, there is no shortage of data sources. The data sources serve as a great starting point and in many cases, serve as an aggregator of information. However, understanding that data to evaluate it in the context of the company’s business, and engaging with management enables a more nuanced judgement of the relevant and material issues and risks in an investment. In other words, while the issues keep evolving and the data sources keep expanding, the process of parsing data to analyze and provide analytical judgement remains the same.
In conclusion
The devil is in the details. A nuanced understanding of business model is needed along with engagement with the company’s management to determine the relevant and material issues that can impact long-term business performance of a company.
The team believes that integrating relevant and material ESG criteria in the evaluation and assessment of a company’s fundamental prospects provides a more granular view of the business and can help in identifying higher quality companies. It can help validate the investment thesis on the companies as well as uncover hidden risks in business models, supply chains, product life cycle, and more.
