How to best address sustainability in our research
Let’s start with a brief overview of our process. When looking for companies to invest in, we start by screening the global universe based on purely quantitative parameters and narrow it down to a number of companies we can handle. Then, we create a short pre-check of each remaining company where we start to take qualitative factors into consideration. Those companies we like the most, we research in great detail, which we call the in-depth research stage. Each stage offers an opportunity to address sustainability concerns.
At the end of 2021, there were about 98’000 publicly traded companies globally. By implementing our exclusions, we narrow down this universe to about 1’500 companies. We screen these 1’500 stocks based on quantifiable factors to reduce them down to about 50. This means we have to remove 29 out of every 30 companies in a way that is meaningful, consistent, and efficient. The best 50 companies are moved to the next stage, the rest are discarded. Sounds simple, right? As always, the devil is in the details.
To narrow down our investment universe, we weight the economic and sustainability data for each company to create a composite score. The composite score captures those aspects of sustainability that can be measured quantitatively. If we want to measure diversity or climate risk, we would use data on the share of women in the executive team, for instance, and the carbon intensity of the company, respectively. These would be quantitative values, and as a result we would have no deeper understanding why a company may have high CO2 emissions.
This approach mirrors what happens with financial metrics at this stage of research; we also do not know why a given company has a particularly high profit margin or low valuation. The composite score simply helps us tilt the list of companies we later research towards our preferred type of company. This is a fast and efficient way of weeding out companies with low sustainability scores, weak economics or high leverage. The drawback is that we might miss out on a company going through changes. Since we repeat this quantitative process twice a year, we hope to catch those companies once their metrics improve at the next quantitative research stage.
The second stage of our investment process we call the pre-check stage. A “pre-check” is a standardized report filled out by one of our analysts to ensure that our “no-go” criteria are not breached and to briefly assess the sensitive topics related to each company. The sustainability section of a precheck report needs to answer several questions.
The first key question considers whether the company specific business model aligns with our values. In the past, for example, we excluded a company because we realized that its business is based on production of single-use office supplies. There is no good reason why an office pen or a paper clip could not be made durable to withstand repeated usage.
As a result, we excluded this company from our investable universe altogether. Another example could be a company, which was not classified as a military supplier based on its data set, yet a significant amount of its revenue was derived from contracts with the military. These are examples of issues that are hard to catch based on numbers only.
The second key question is whether our sustainability minimum standards are upheld. For this purpose we developed a flag system to be alerted whenever the sustainability performance of a company does not meet our minimum criteria (Figure 2). The themes in the flag system are primarily based on our workshops and are thus based on our values and preferences. A red flag appears whenever a company does not meet our minimum criteria in a particular issue. This helps us catch a killer criteria early on and terminate the research before spending weeks or months on in-depth research.
The third key question in any precheck report is whether there is enough information for us to conduct an in-depth research report. Since we spend several days on a precheck, this gives us sufficient time to get an impression of a company’s transparency and reporting quality and to assess whether we have all necessary information with sufficient validity to conduct further research on a company. About one in ten companies passes our precheck stage. If it passes, we initiate a full-fledged research report. The in-depth stage entails extensive research into the business model, financial reporting, culture, competitive position, risk exposures and sustainability profile of a company. In terms of sustainability, we now have the time to go far beyond the precheck both in terms of the breadth of topics and the depth of analysis. Let’s illustrate this with our examples.
Diversity in the previous research stages was addressed using the parameters: share of women on the board of directors and executive committee. This is because we find gender diversity important, easier to quantify, and companies frequently report on this ratio. During our in-depth research, we broaden our understanding of diversity. We look for board of director compositions with varied professional experience, age, and backgrounds. We analyze the CVs of the directors on the board and all executive team members and evaluate whether these teams have diverse enough backgrounds to oversee and run the company we are researching. For example, we once excluded a company from further research because every member of the executive team had a background in marketing. We also excluded a company where the board – although diverse in terms of gender and educational background – was composed of family members that were also related to management.
Similarly, we prefer companies where Chair of the Board and the CEO are two different people. We believe that the separation of these roles is better for the company oversight as well as its risk management. However, this criterion is a preference and not an exclusion metric, meaning that in the precheck stage we would highlight the potential overlap between the two roles as an issue to be researched but not discard the company from the research universe if other metrics meet our criteria.
If we decided to research a company where the CEO is also Chairman of the Board, we want to understand how the Board of Directors really operates in order to provide an effective oversight of management and what the succession plans are for each of the position. We would also try to understand if there is another person balancing out the power concentration such as a major shareholder, founder or otherwise influential person. This type of information cannot be handled quantitatively which is why we focus on it in the in-depth stage where we have space for thorough qualitative analysis.
In the previous example of carbon emission, we focused on the carbon footprint in the early stages of the research because it is a quantifiable value that can be easily compared to peers. In the in-depth research stage, we would focus on the transition aspect of the company’s emission. Are there any targets in place?
Can we trust and verify those targets? What actions are the peers undertaking and can we consider this company to be a leader or a laggard? We will be in direct contact with the company to understand why certain alternatives have not been explored or talk to people within the company and former employees to get a feel for how serious implementation efforts are. This helps us also understand whether the management acts based on outside pressure or personal conviction.
Does the management have the courage to initiate change within the industry? In this stage, we allow ourselves to take the time to really dig deep into the culture of a company to understand where it is today, and where it might be tomorrow.
Example: Sustainability & financials
Our precheck identified a company producing hygiene products as an interesting candidate for in-depth research. In a business we considered commodity-like, we were surprised to see profit margins significantly higher than the peers. Given the potential environmental issues linked to hygiene products, we decided to start the in-depth research with a sustainability analysis. Using the materiality map, we quickly realized that the improved margins came from using cheaper (and dirtier) sources of energy. Once the company would comply with the upcoming government regulations, its margins would level with its peers who were already compliant with the regulation. Hence, we discarded this research and moved on to analyzing another company.
How do we know what issues warrant a rigorous investigation? The breath of the sustainability research in the in-depth stage is driven by the materiality map from the Sustainability Accounting Standards Board (SASB). The tool outlines which topics are material, i.e. meaningful, for each industry. While the precheck helps us focus on the sustainability criteria that we as a team find important, the SASB’s materiality map points us to the crucial issues in each industry that are now taken into consideration.
In Figure 3 we are providing an example of material topics for Stock Exchanges and for Software companies. Today, most stock exchanges no longer include a pit where people trade in person; rather, the exchange has moved online and trading is done electronically through trading software. Often this software is developed in house. So one might think that securities exchange and software companies might have similar sustainability issues. And yet, the topics that are highlighted by the SASB’s materiality map are substantially different. This is why we find it important to work with the materiality map that was developed in collaboration with sustainability experts in each industry. As a result of this approach, the outcomes of the sustainability research differ from company to company. What stays constant is the rigor of the analysis, the links to the financial analysis, and the ultimate impact of the sustainability analysis.
Throughout our in-depth stage, we are in touch with the company we research several times. These repeated calls provide us with the opportunity to raise sustainability issues that we have identified and discuss the more forward-looking elements of the sustainability strategy. These inquiries also help highlight to the company itself that the investor community values sustainable behavior. For example, we researched a company based in the USA that did not have a convincing sustainability strategy in place and was not setting any sustainability targets, although its metrics in the flag system were sufficient to move to the in-depth research stage. We talked to the company several times, highlighting these issues. Since the company did not show any serious interest in these topics and our concerns were not addressed, we had to put the research aside. A few months later, the company reached out to us explaining that our concerns helped change the internal thinking and the company is now working on a sustainability strategy. This helped us move the company back into our research universe and if it ever proceeds from the screening stage again, we will be ready with our research and our existing relationship with the company.