Investing: Understanding non-financial risks

Responsible investment is the topic du jour in the global investment world.

Tuesday, August 21st 2018, 8:30AM

by Pathfinder Asset Management

Karl Geal-Otter, Pathfinder Asset Management

Unfortunately, in New Zealand, the focus is largely on only one part - “Negative” exclusions. This involves removing companies in a portfolio that are involved in egregious industries, for example, controversial weapons, gambling, tobacco and thermal coal. This is a good first step but it's not enough. Going beyond exclusions, investors can use current controversies and Environmental, Social and Governance (ESG) scores (positive factors) to better understand future non-financial risks.

Research says using ESG works. A 2016 report by Bank of America Merrill Lynch found that investing only in the above average ESG scoring companies helped avoid 15 of 17 bankruptcies in their US stock universe, since 2008. While we’re not talking bankruptcy, Facebook is another real-world example of ESG scores helping to understand a business.

The Facebook example

Facebook has had a howler of an earnings season. A 42% growth rate in revenue would be a miracle for most companies but for Facebook, a high growth company with temperamental shareholders, it is the first guidance miss since 2015. Daily and monthly user numbers are also slowing, whilst its cost of business is expected to increase faster than revenue this year and into 2019.

After two years of negative headlines, data breaches and election meddling, shareholders had finally had enough. Facebook’s share price reacted to this negative news flow in late July – losing 18% in a single day. Losing US$120 billion is a lot, that’s more than the total market capitalisation of New Zealand.

Facebook has been unbelievably successful leading up to this point. But, the company is now starting to pay for years of a grow-at-all-costs mantra.

Learning from BP’s disaster

Using an ESG scoring framework can provide insights into future financial costs for a company due to some incident or wrongdoing. Take the BP Deepwater Horizon oil spill as an example – an environmental impact that cost the company billions from not having proper checks and balances in their environmental policy.

Facebook is in a similar position. It has long had a poor governance rating, its governance score is one of the lowest of US-listed large-cap companies. Understanding its poor governance model and the very vocal gung-ho growth message from management, an analyst looking at more than just financial data may have been a little more pessimistic about the future of Facebook. And they should have, the company now needs to hire an additional 20,000 staff to deal with data security and political meddling. Facebook’s CFO, David Wehner, told investors the company is “making significant long-term investments” in safety and security. And that “those investments are in the billions of dollars per year; those will have a negative impact on margins”. How much? Almost a 10-percentage point decrease in margins from costs that could grow by 50-60%, into 2019. Grow-at-all-cost now has a cost.

Why ESG?

Avoiding these future financial risks is where responsible investing can not just do good (in terms of ethics) but add real financial value to a long-term investor. Poor ESG scores are a long-term indicator – they won’t tell you if a share price disaster is happening in the next week. But the share price impact from a serious ESG event can be as big as a company reporting a massive earnings collapse. As responsible investment evolves and becomes mainstream, the impact of these non-financial risk factors becomes more visible.

Negative screening takes away “bad” companies in “bad” industries. A fully integrated ESG policy takes away the “bad” companies in “good” industries. Responsible investment (through the assessment of non-financial factors) can add real value for investors.

Karl Geal-Otter is an investment analyst at Pathfinder Asset Management, a boutique responsible investment fund manager. This commentary is not personalised investment advice - seek investment advice from an Authorised Financial Adviser before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

Tags: ESG investment Pathfinder Asset Management