Insights categories - ESG

Navigating valuations and values since 1973

ESG analysts Raine Adams and Nicole Hamman describe what responsible investing means to us, and demonstrate how we use a strategy of environmental, social and governance integration and shareholder engagement and action to serve as good stewards of our clients’ capital.

As Allan Gray celebrates its 50-year anniversary, we feel proud to work for a company that has always prioritised the protection of clients’ interests, and fortunate to learn from those who came before us. Allan Gray has a very long history of standing up for shareholders’ rights when an escalation in action is warranted. While the methods to do so have changed as shareholder rights have evolved, the principles have remained the same.

Responsible investing has grown in prominence over the past decade. However, if you ask 10 people what responsible investing means, you will receive a range of answers. This is because it tends to mean different things to different people, and the confusion has been exacerbated by ambiguity in the investment industry.

Responsible investing is in fact an umbrella term encompassing five approaches, with important distinctions. These are:

  1. Environmental, social and governance (ESG) integration
  2. Shareholder engagement and action
  3. Screening (positive or negative, often known as exclusion strategies)
  4. Sustainability-themed investing
  5. Impact investing

At Allan Gray, we have always focused on 1 & 2.

ESG integration in fundamental research and investment decision-making

Valuing investments is much more than a numbers game. Take two mining companies as an example: Both are trading on low multiples of their free cash flow, in a net cash position and well placed on their sector cost curves. Which is the better buy?

This question cannot be answered without more context. Among other things, research must consider which has a more favourable commodity basket, a better management team, operates in more stable jurisdictions geopolitically and socially, operates its mines more safely, and how each is managing its environmental permits and liabilities. ESG integration is often viewed as a “soft” topic, but the considerations listed above are in fact all environmental, social or governance concerns, and ones that can have a material impact on companies’ prospects, cash flows and valuations.

Our views on the above are informed by a combination of quantitative analysis (the number-crunching) and qualitative (non-numerical) research. For example, we evaluate a management team by assessing their capital allocation track record, operational productivity and financial metrics under their leadership, and considering whether their remuneration incentive structures are likely to align them with long-term shareholders such as our clients. We also rely on our meetings with them and using third-party inputs, such as allegations of unethical conduct.

Every valuation must be viewed in context, and ESG factors are important pieces of this puzzle. This is why we considered them as part of our investment process long before responsible investing was fashionable. As an example, the first policy group report we have on file is a typewritten report from 1982. The investment case notes several governance concerns to consider: the controversy of pending litigation, confidence in management, the political landscape and succession risks. Another report produced in the same year opens with: “[The company] is an excellent operation with sound, very conservative management …”

We believe ESG integration can improve investment returns, better manages risk, and assists our clients in acting as responsible owners. In other words, it protects our clients’ interests as long-term investors.

But there are complexities: Some ESG issues are systemic, while others are idiosyncratic; they may manifest over different time frames; they may be high-impact, but improbable, and they are often viewed through the lens of people’s personal value sets. The most difficult is that there are often trade-offs between E, S, G, and economic factors, or even within them.

An example of the latter is South African gold mining companies, which, in terms of the social pillar, have poorer safety performance than their global peers – due to the deep-level, labour-intensive nature of our mines – but they employ tens of thousands of people in a country with high unemployment and poverty.

Emerging market sovereign debt is another interesting example. While we may disapprove of the relevant government’s regime – a “macro” governance issue – the proceeds of this lending go towards infrastructure development, which theoretically leads to necessary social upliftment.

Valuation-based vs. values-based investing

We try to assess ESG factors holistically in our research and form a balanced view. In our opinion, ESG performance can never be adequately conveyed in a condensed ESG “score”, as has become popular in the investment industry. One final score or number per company fails to convey the nuances and complexities that are inherent in ESG evaluation. These same complexities are why, despite our best efforts, we will not always get it right.

Our primary job is to distil the factors most material to the investment case, recognising the differing local contexts. And our conclusions are not always what one may expect. A company with a poor governance history may still be a great investment if the market discount placed on the stock is substantial enough to offer a sufficient margin of safety and our research provides enough comfort that prior failures are being tackled.

On the other end of the spectrum, an “ESG leader”, such as an offshore wind company, which requires high upfront capital expenditure and associated financing, may result in poor investment returns in an inflationary and high interest rate environment.

In this respect, we are not solely a values-based investor, which is prone to subjectivity when investing on behalf of a broad range of clients. That said, we always encourage companies to operate honestly and to minimise harm when they have negative environmental and/or social externalities. For example, at Sasol, we have encouraged a focus on reducing air pollution and formulating country-appropriate strategies for reducing greenhouse gas emissions. At Sibanye-Stillwater, we have met with management to voice our support for their ongoing focus on improving safety outcomes at what are inherently high-risk operations. Apart from it being the right thing to do, it is an important part of a company maintaining its societal licence to operate and should ultimately contribute to long-term sustainability.

Shareholder engagement and action

Our overarching objective has always been to preserve and grow our clients’ wealth over the long term. Our clients are shareholders in the companies in which we invest, and we act on their behalf. Considering that companies’ operational, financial and ESG performance is dynamic, and that we live in an ever-changing world, we remain active on behalf of our clients once invested.

Historically, Allan Gray has even pushed for the reconstitution of a board of directors when the board and management were failing to adequately unlock shareholder value. This was the case with agribusiness OTK in 2000, when Allan Gray, together with Brait, represented more than 50% of the shares in issue and requested certain directors be replaced with directors with a background in finance. It was also the case in 2017, when Allan Gray, on behalf of its clients, called for an extraordinary meeting of shareholders of construction company Group Five, which led to the reconstitution of the board. Unfortunately, in Group Five’s case, our efforts were not enough to save the company. Nevertheless, it set a precedent for the use of the new Companies Act by shareholders and their representatives as an effective lever to replace non-executive directors. Demonstrating our willingness to use these accountability mechanisms when warranted is an important part of our ability to influence change during engagements.

How we consider ESG in our investment philosophy has remained unchanged since 1973, but we strive for ongoing improvements in our research and processes. For example, while investment analysts remain primarily responsible for researching ESG issues related to the companies they cover, specialist governance (G) analysts, and specialist environmental and social (E&S) analysts have been employed since 2013 and 2017 respectively to support the Investment team’s ESG integration and engagements. Today, among other sources, we have developed a proprietary “controversies database” to monitor adverse news flow relating to companies in our investment universe, which has been a useful additional data point for uncovering new risks or a growing trend for further investigation.

As touched on above, our activities focus largely on the decision-makers – management and the board – given their substantial influence over value creation and destruction. Poor decisions are reflected in the numbers, but they also tell us that the executive remuneration scheme is not disincentivising value-destructive behaviour, and that poor decisions are getting past the board of directors.

We keep striving to remain responsible stewards of your capital.

Our continued focus on executive remuneration

As long-term shareholders, our clients benefit from corporate governance structures that yield positive decision-making. The objective of our remuneration engagements and related proxy voting is to encourage improvements to companies’ existing remuneration schemes to better align them with shareholder outcomes – that is, to discourage short-term thinking that may impact long-term sustainability. We also prefer management to have an equity position, or “skin in the game”, alongside our clients.

A good example of this is Mondi: The CEO shareholding requirement is 300% of their total guaranteed pay, which is currently being met. The timeline to meet the requirement is defined at five years from the appointment date, which provides clarity for incoming executives, and the requirement is bolstered by a post-employment holding requirement of two years.

Each company is unique, and the issues are nuanced. We try to get the balance of views right, meaning that our ESG analyst, investment analyst and portfolio manager are present in the engagement to ensure we are not taking an isolated view on any one aspect.

Our approach of ESG integration and shareholder action does not involve two strategies, but the continuation of one. The material risks to the investment case go on to shape our suggestions. For a company such as Life Healthcare, which is focused on patient care, we have encouraged the use of patient outcomes as a key performance indicator (KPI) in remuneration (although our engagement on other necessary improvements to the scheme is ongoing). This is not only socially responsible, but material to the investment case to compete effectively in the private healthcare space. Alternatively, such as in the case of Sasol, where historical cost overruns on the Lake Charles Chemicals Project negatively impacted shareholders, we have scrutinised the remuneration scheme’s performance metrics to ensure it encourages value-accretive behaviour.

We have found that the implementation of our suggestions often requires patience; some of our historical engagements on remuneration (and other ESG factors) have spanned many years. In the case of Investec, we went from voting on behalf of our clients against the remuneration policy in 2014 to voting against certain directors in 2016 and 2017 when (in our view) critical improvements did not materialise. We began supporting the policy once significant improvements were made in 2018, and value has since been created for shareholders through the unbundling of Ninety One.

Nevertheless, we respect that it is a tough task for remuneration committees to balance differing shareholder views, and we are mindful that they must build a constructive relationship with management before improvements can get over the line.

The last line of defence: the board of directors

As representatives of our clients’ interests as shareholders, we are outsiders to the decision-making process. For example, we do not know what transpires in the boardroom. While concerns are often raised around whether long-serving directors can exercise appropriate independence in their oversight capacity, it may be the longest-serving non-independent director (who, based only on long tenure, attracts the largest shareholder opposition when standing for re-election) who exercises the most independence of mind behind closed doors. Alternatively, the remuneration committee could be just a formality while a dominant CEO is structuring their own pay.

We rely on our engagements and company outcomes under the directors’ oversight to inform our voting recommendations for our clients. We have been tracking negative outcomes on our internal “directors database” since 2015.

From then to now

A lot has changed in 50 years. In 1973, the year of Allan Gray’s inception, the first mobile phone was developed by Motorola and weighed a hefty 1 kilogram. Two decades later, IBM developed the first smartphone, and 1999 saw the commercial launch of cellphones with internet services – a now ubiquitous part of many of our lives. Disruptions continue across industries. In 2013, only 206 000 electric vehicles were sold, whereas over 14 million are expected to be sold this year.

Even in the past three years, a lot has changed, and we credit company management teams and boards that have shown remarkable resilience in tumultuous times. Since 2020, South African companies have navigated COVID-19, devastating riots and floods in KwaZulu-Natal, crippling national loadshedding and failing infrastructure, and supply chain disruptions due to the Russia-Ukraine war. While some of these were unavoidable, it is a sobering thought that the greatest ESG risks facing “SA Inc” companies today are the (avoidable) consequences of government corruption and mismanagement. It is also why, despite our bottom-up stockpicking strategy, we ensure portfolio earnings diversification to manage these and other risks.

Times are tough in South Africa, and it is easy to feel despondent. But we should keep working towards a better tomorrow. This responsibility is on all of us as South African citizens.

Thank you for being clients of Allan Gray. We keep striving to remain responsible stewards of your capital.

For more details about our stewardship efforts, please see our latest Stewardship Report.

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