Transcript

Paul O'Connor (POC): Welcome to the Netwealth Portfolio Construction podcast series. My name is Paul O'Connor, and I'm the head of investment management and research. The investment management and research team looks after both the investments we make available to you through our super and non-superannuation investment platforms, but also the managed funds and managed accounts that we issue. So, we naturally spend a lot of time interacting with the fund managers. The due diligence we undertake provides lots of insights into the views on the global economy, financial, and the investment strategies offered by fund managers. Today, we have Mans Carlsson-Sweeny from Ausbil Investment Management, who's the head of environmental, social and governance research, who works with the broader Ausbil investment team in Sydney. A key part of Mans role is to integrate ESG research into Ausbil's broader research and valuation of companies. Good morning Mans, and welcome.

Måns Carlsson-Sweeny (MCS): Good morning. Thank you.

POC: The Investment podcast series in recent months has focused on COVID-19 and the impact on the global economy and markets. But I thought for today's podcast, we'd focus on ESG and how investment strategies such as those offered by Ausbil are incorporating this research into their standard research process. Ausbil have a broad range of active equities managed funds available on the Netwealth superannuation and IDPS investment platforms, covering Australian equities, small cap, micro cap, equity income, global small cap, and infrastructure funds. ESG investing has really become mainstream in recent years, and the broad industry acceptance probably goes back to when the United Nations invited investors to develop principles for responsible investment, and this resulted in the UNPRI being launched in 2006.

Perhaps to start, and for the benefit of some listeners, environmental, social and governance is the most commonly accepted form of responsible investing and involves incorporating ESG research into the standard research undertaken on a company. In my opinion, I guess, it's really about assessing whether a company is considered a good corporate citizen, including how they treat staff, and the environmental impact of the goods and services produced. I'm sure Mans, you would have your view and thoughts on the whole development of ESG in the industry there, but I guess you'd be seeing an uptick in interest from Ausbil clients?

MCS: Yeah, and I think it's correct. Like you said, it's evolved over time. And it really started out as ethical investments a long time ago when clients were happy to forfeit returns, as long as they avoid a certain sector. So, we're basically investing with our hearts. And that meant screening out companies in controversial activities like tobacco, gambling, weapons, et cetera. But the industry is evolving, and it continues to evolve, too. So, if you fast forward to today, the investment community uses ESG for a different purpose, and that's really to ultimately drive better returns. And if I look at why we had Ausbil integrate ESG, I think you can boil it down to two things. First, we think we can make better informed investment decisions because you're taking into account additional factors that might have been overlooked or maybe mispriced by the markets. And the second aspect is active ownership or engagements with companies for better investment outcomes.

If I go back to the better informed investment decisions there for a second, to put a simply to me, if a business model relies on underpaid workers, weak regulation, under-price pollution, et cetera, those current earnings will not be sustainable over time. I think that's the heart of what ESG is to me. And then the second element, engagements with companies on the ESG issues. I think that's another element that's only growing in importance, and that's definitely a trend. Going forward, as responsible investment continues to evolve, I think there'll be more focus on ESG outcomes because you have something called the UN sustainable development goals, the SDGs, and that's a set of goals that the UN is set to achieve by 2030. Examples include eradicating slavery, cleaner energy, et cetera. And the PRI, as you mentioned before, that I actually endorse those goals and so have many companies. And we just think societal values are changing and capital flows also changing as a result. So, companies have a vested interest in becoming good, cooperating citizens.

POC: I think it's a key point you make there Mans, in that ESG investing does not have to be about giving up any level of return. And I think you even made the comment that it can lead to out-performance over the longer term there for investors. Whereas historically, particularly the earlier forms of ethical investments simply just took out certain companies from their investment universe. And to a degree, it could have an impact on the return of the portfolio over time. So, I guess that understands, and it certainly resonates in terms of the example you provided there about a company with a poor practise that over time is not sustainable, their earnings, and it will impact on them. So, moving on there... So, we've spoken a little bit about how it's developed ESG over recent years. And I think recently I saw there were almost 2000 signatories to the UNPRI and well an excess of 70 trillion in funds under management of signatories to the PRI. When did you actually get involved in ESG research, and what attracted you to this area of research?

MCS: Right. So, I was working in London at the time. This is back in 2007. So, I was on the sell side working for a Swedish investment bank. And at the time, I felt that there were quite a few companies in Scandinavia because I covered Scandinavian equities, that were actually trying to be good corporate citizens, but they weren't always articulating the business rationale for doing so. I saw the writing on the wall, I guess, in terms of the sustainability drivers and external environment favouring such companies in the longer term. And I started doing some research and then started to produce research and sold that research to external clients. And also, I think it's a passion of mine. I could talk a bit more about that later on, about humorizing climate change, but I think the world is changing. There's a lot of issues out there, and we think as investors, we can be a source for good and held capital being allocated the right way.

POC: I think, yeah, interesting comments you make their, Mans. When I look at ESG, at times, I do find a certain level of introspection in looking back on myself and how I actually make decisions in terms of investment management. So yeah, I think it's certainly resonating more strongly across the market. It's certainly been an increasing level of popularity amongst investment and advisors, ESG investing. But assessment of a company's ESG footprint is not a simple black and white exercise. Can you perhaps explain to the listeners how you think about ESG, just in terms of how that process has evolved in recent years?

MCS: Yeah, sure. It's probably going to be a bit of a long answer here, but I think the starting point is that ESG is very intangible by nature. And it can also be quite subjective, but therein lies the opportunity as well. So, the way we do it at Ausbil is we don't buy any third party research from any external provider because we think the Australia investible universe is small enough for us to do our own proprietary ESG research in house.

So, we have a team that I head up consisting of three people, and we sit within the broader investment team, and we also collaborate frequently with the financial analysts. And we think it's also the best way for us to find usable and actually tradable insights on ESG, to do it ourselves. So, just as an example to illustrate that, a couple of years ago or more than a couple of years ago now, we found anecdotes about underpaid workers in a certain franchise company. And we found those issues long before media started to write about it, and we could act on that information, and we even took a short position as the stock was trading at a very high multiple. And then of course, when journalists started to write about this particular company, the stock fell sharply. And I think it's a good example to showcase that if we had relied on... And I think it's a good example to showcase that if we had relied on company disclosure only, we would not have found that insight. If we had relied on third party research, we most likely would not have got that insight either because third party research itself is based on public disclosure by companies anyway. So we prefer to do the research ourselves. So when we do that research, we rely on a wide range of information sources.

In this particular case that I mentioned, it was anecdotes in social media that we use. But we also look at things like independent staff reviews. We speak to people who work in industry. We speak to other stakeholders like unions, NGOs, et cetera. And of course we speak to brokers and companies. There's really just trying to piece together that puzzle. But coming back to the way we do it in practise, we do proprietary ESG research on the ASX 200, and a number of smaller companies beyond that too.

And in practise, that means every company that has an ESG score ranging from one to five, where five is the best, and one is the worst. And what we do there is we score them on their maturity of ESG risk management. But more importantly, I think, every company that has an ESG SWOT analysis, so strengths, weaknesses, opportunities, or threats related to ESG. And that's where we flag any potential earnings risk opportunities that we think need to be factored into the investment analysis. And sometimes they can relate to issues that we think that the market hasn't priced in. And that's also where we give our view on what we think of management and the board in terms of quality.

We also look at how management is incentivized. And behind that, of course, there's some very big in-depth analysis of a company in terms of all things ESG. And that obviously differs then between companies in different industries. So if I look at a FinTech company, for instance, I would probably put most of my focus on how they manage human capital. Things like staff engagement, staff turnover, but also R&D, as well as cybersecurity. For a mining company it's more about how they're positioning themselves in a world that's decarbonizing. How they'll manage things like water risk, health and safety, environmental risk, et cetera. So the research covers a wide range of factors and it differs a lot. And then-

POC: I was going to ask, are there trends across various industries in terms of the grading of the companies, or is the ESG analysis fit well, does it differ per company? And you've got to look at each company. I mean, you made the comment around mining companies, and I can appreciate that have different ESG challenges to a FinTech company. But are there any industry trends, per se, when you're looking at those companies?

MCS: And what I mean by a de-carbonization is, of course, the Paris Agreement and climate change. So we think there's an inevitable process to happen, which is the world needs to decarbonize, in order to mitigate the extreme risks that we see from climate change over the longterm. And then coming back to the ESG scores, once we've done with those and the ESG SWOT analysis, we then sit down with the financial analyst who covers our stock. And ultimately he or she then incorporates that into his or her investment recommendation.

Another aspect of working together with the analyst, I guess, is when we see companies we always do so as a team. So it's their portfolio manager, it's their stock analyst, and it's myself or someone from my team. And we think that's the best way for us to raise ESG concerns directly with a company and discuss ESG issues. And we want to do that at a board level or management level.

POC: Yeah, it's interesting, I guess, to your earlier comments there around that actually employ ESG analysts as part of the investment research team. And historically I have seen managers just buy-in external ESG research, or the internal ESG research is very separate to the broader investment team. And I've always thought that the better managers would have it just all incorporated into the one investment process and take when looking at a company. I'm glad to hear that Ausbil have taken on that structure in providing ESG overlays on the portfolios.

Ethical investing strategies for precursor, I guess in my mind, to ESG. But otherwise then can be quite confusing given that individual's ethics can vary considerably pending their socioeconomic background, education, religion, et cetera. What are the key considerations of an investor when assessing the veering ESG investment strategies that are now available?

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MCS: Yeah. Look, I think that's very true, ethics can vary a lot. So various investors might have different perceptions and values. In some cases, though, I think there is a big overlap between what I consider classic ethical investment and ESG integration. So if you look at something like tobacco, for instance, an ethical investor might argue that tobacco is morally wrong, and therefore it should be excluded from investible universe. Whilst from my ESG perspective, I might foresee increasing regulation because of the societal costs from tobacco, and therefore that's going to limit earnings growth going forward. So we might come to the same conclusion, although from different angles. I don't think they're always mutually exclusive, ethical investments and ESG, but they often come from different angles. When it comes to considerations when assessing ESG investment strategies, I would say this, and it comes back to your point before about truly integrating ESG. Because ESG means different things to different people. And it can be integrated in different ways.

The key point there I think is to look at, is the ESG integration aligned with the investment philosophy? Because if it's not, I think there's always going to be a risk that the ESG component becomes an overlay or something separate. If I look at how we do it. Well, our investment philosophy is quite simple, we believe that earnings revisions drop share prices. And we have a preference trends for companies with strong management quality and sustainable earnings. And with that, we think that's a very natural link to ESG. For instance, if you have a company underpaying workers or mistreating customers, well, that will be an impact on earnings. And even if you distance yourself from earnings and just look at the quality of management perspective, I actually think ESG is a very good proxy for management quality.

So say for instance, you meet with a company and you realise that they're only paying lip service to an issue like gender diversity or human rights in 2020. And I think that just says something about the management quality of our company, because the ramifications of paying lip service to gender diversity in this day and age can be quite significant. You might face higher staff turnover, lower staff engagement, and low productivity over time. So even though there's no direct earnings hits in the short-term, it's still a very valid point. So we use ESG very much as a quality factor, a qualitative factor and an assessment of management quality.

POC: Yeah, well, I guess back to my opening comment there. That makes sense for mine, [Mons 00:08:42], because of my view that ultimately companies like individuals should be good citizens of the planet. So in assessing a corporate management team through an ESG lens, I think would give a lot of insights into the quality of the team. How they're running the company would also assist your broader Ausbil investment team, I would have thought.

MCS: Yeah, exactly. Yeah. And another thing which I think is really important in the context of ESG investing is that integration of ESG doesn't always have to mean that you invest in the companies with the very best ESG profiles. It's also about finding the companies that are improving. Because from an alpha perspective, we think if you only invest in companies with the very best ESG profiles, you might end up with quite an expensive portfolio. But if you find the companies that are low in valuation, but they really want to improve in ESG, well, maybe that's something to take into account when you make your investment decisions. Because over time within companies was strong ESG profiles will trade at a premium. So we pay a lot of attention to indicators like, if you look at the mining sector, for instance. How is a company's safety performance tracking? Because if a company is improving on Because if a company is improving on safety, well that means fewer production disruption going forward, probably less staff turnover, et cetera. Same thing for a bank. If you look at the way the bank is managing people and what is the level of staff engagement there? So often we've actually used those anecdotes in terms of deciding where to go overweight in a particular sector.

POC: Yeah. It's interesting. And further to the comments you made earlier around advocacy and engagement, can you talk about the type of advocacy and engagement that you undertake with the various companies that you are either holding in a portfolio or you're meeting and review?

MCS: Yeah, I think the starting point there is Australia is a fairly small investible universe to start with. So you don't have a lot of choice, always when you invest in companies and because we're blessed with good corporate access here in Australia, we just think managers like ourselves are naturally incentivized to engage with companies. So it does play a big part of our integration.

In terms of how we do this, every year we have an annual ESG engagement plan. So we set out objectives for our engagement activities and what we're actually trying to achieve. And we have a number of themes that we engage on. Some of the key themes for us in the last couple of years have been climate change obviously. Human rights, which I'm happy to talk more about later on, has been a big theme for us. Corporate governance, improved ESD disclosure, but also plastics and recycling. So every year then, at the year end, we issue a summary of all our engagement activities, which is on our websites. I think last year we engaged with companies on ESD issues over 170 different locations. So there's a lot of interaction going on and obviously those engagements vary in terms of depth. In some cases, it could be about raising an issue. Other cases, it could be that we want to come to take a certain course of action. And I'm happy to go through a few examples maybe if that's helpful.

POC: Yeah, I think it would be great. And then it would be great to understand too is, if you've got any examples too where potentially your engagement has influenced some change in a company?

MCS: Absolutely. And it's always hard to know exactly what impact you have had as an individual investor, but there's a lot of investors that engage in the same themes. But I think if I take that question that from an industry perspective, I would say investors have been quite influential on both climate change and human rights.

So we, as AUSBill and other investors too, we've encouraged companies to report against a standard called TCFD. So that stands for the Task Force on Climate Related Financial Disclosures, TCFD, that's a voluntary framework that asks companies to issue a scenario analysis to showcase how they predict they will be affected by climate change and decarbonization in the short, medium and long term. We have also encouraged companies to set climate change goals and greenhouse gas emissions targets, et cetera. And there's actually been a fair bit of progress in that area. A number of companies have then adopted these TCFD standards, they have set carbon reduction targets, et cetera. So that's helping in terms of combating climate change.

Another area is human rights in the supply chain. As an investor, I guess you can either just point a finger or you can actually try to be part of a solution and we've taken the latter strategy. So I've been to a number of field trips and I've visited garment factories and other factories in places like China, Bangladesh, Cambodia, Thailand, et cetera, over the last couple of years. Of course, when you go there, you never get to see the worst factories because they'll know you're coming, but you get to see the best ones. And to us, that has value too, because by speaking to unions, NGOs, workers on the ground, first of all, you can get a feel for the complexities, but also when you speak to the leading retailers sourcing from those factories, you can learn what's best practise on human rights risk management.

Then of course, you take that information with you when you go back to Australia and you encourage our retailers here to adopt those best practises. And we think we've had a fair bit of success on that. It doesn't happen overnight, but we've had some various strong messages to companies in terms of what we think they should be doing to minimise the risk of brand damage and sweatshop scandals. Of course, things can still go wrong, but at least their risk is lower. To us, it really comes down to how you engage with companies. You need to do it in a very constructive way and we think it makes sense to have a whole strategy.

POC: It's interesting. So you believe that human rights are improving, including a lot of the emerging countries? We see a lot of mainstream media give attention to some of the Australian retailers and having garments made off shore. So yeah, it's positive to hear. I think that, as investors, we can make a change by engagement and your example, there is a good example I think there Mans. So do you think the take up of the modern slave around the world has increased the protection for vulnerable workers in addition, I guess, to the dialogue and the societal pressures to improve human rights?

MCS: Well, I think companies are realising that the tide is turning and they need to be better aware of the risks and manage those risks better. But if I come back to human rights, it's a massive topic. Even before the COVID-19 environment, it was estimated to be about 40.3 million people living in modern slavery conditions, which means slavery is actually more prevalent now than ever before in human history. When I say modern slavery- It's massive. I mean, 40 million people, when I say modern slavery, it includes things like forced labour, bonded labour, the worst forms of child labour, et cetera. But of course the COVID-19 environment is actually making this even worse. So I'm a bit worried about that. But I've always argued that there's a fine line between what's a modern slavery per se and labour standards in general because slavery doesn't just magically happen. It often takes years of poor labour practises for slavery to emerge. So we think it makes sense for us investors to not just focus on slavery per se, but looking at human rights in a broader perspective.

And, in terms of the modern slavery legislation in recent years, which you asked about, it's quite interesting. There's been quite a few regulatory developments. It started with the UK, which introduced the modern slavery act a few years ago. And then in Australia in 2018, we introduced a similar act here. And just to explain what that is, it mandates that any company or any organisation with over a hundred million dollars in revenue per year and operations in Australia, need to issue an annual statement that covers seven mandatory criteria.

Essentially those criteria boil down to three things that say, what are the risks of slavery in your operations and supply chains? The second part is what have you done about it? And the third part is how do you measure the effectiveness of that? And that means there's a transparency act. In other words, it's about disclosure, but hopefully this will be the starting point because mandatory disclosure will hopefully translate into more action to combat slavery. Although when I speak to companies about this, there seems to be two types of companies out there.

One is the type of company that sees this as a legal compliance exercise, and just issue statements and doing the bare minimum. But then there are those companies too, that see this as an opportunity to have better visibility over their own supply chain and go over and beyond the legal requirements. I think the background to why we're seeing so much legislation in this area is that governments have realised that no government in the world will ever be able to eradicate slavery on their own, because it's a hidden issue. It's often deep into supply chains.

So they think businesses, investors and other stakeholders can contribute to that progress. And as an investor, we think we have a big role to play. The way we engage with companies is as I mentioned before, about adopting what we think is best practise. And we've also, in addition to engagements with companies, we've also engaged directly with the government.

So last year we were in a panel of experts assisting the government to do the guidance for the Modern Slavery Act here in Australia. We've also been more recently appointed as one of the 10 experts on a panel that will assist the government in implementing the Act over the next 18 months. So the key role for us as investors here is to engage with companies. And let's not forget also that the Modern Slavery Act per se also applies to us investors. So we need to be on top of risks in the portfolios we manage, which I think makes the Australian Modern Slavery Act quite pioneering in that sense.

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POC: Yeah. And I guess as you're talking again, I'm thinking it gets back to the quality of the management team and whether they genuinely live and breathe human rights as a concern, or whether it's a box ticking exercise. And I think, again, that in my mind highlights the active management, the engagement with companies will uncover these types of insights. So it's interesting comments you make there Mans.

Just changing the questions a little. Have you got any views on the impact that rising geopolitical risks will have on ESG investing? In particularly, I guess a growing divide we're seeing between the US and China?

MCS: It's a really interesting topic. I think those tensions will just accelerate. An existing trend that I picked up on a few years ago, which is manufacturing leaking out of China. If you look at China, for many years, wage inflation has driven up the cost of manufacturing there. And the natural response to that has been Chinese factories is packing up and then setting up new factories in places like Cambodia, Vietnam, et cetera. But often with Chinese capital. And they're basically just moving the manufacturing capacity overseas. And China has bigger aspirations than just being the world's manufacturing, low wages and low skilled workers. They want to move beyond that and China want to rise up in the world and gradually reduce their reliance on low skill manufacturing. We're seeing that through the government's increase in minimum wage and also focus industries for the future, tough environmental laws, et cetera.

I think the shift of manufacturing out of China probably would be happening, anyway. But what it means for us as investors and companies, I guess, is when a company's supply chain is shifting to a new location with that comes new types of risks, as well, because the ethical sourcing risks in China are quite different from those in Cambodia or Myanmar, for instance.

And it is, means that the companies need to be on top of that and understand the local challenges specific to where they're sourcing from. The other thing with a global economy at the moment, I guess, the whole potential de-globalisation as a consequence of the COVID-19 and also some political tensions. It'll be interesting to see how that's going to play out and how much of the previously offshored supply chains will actually be brought back onshore again I think we'll just have to wait and see what's going to happen there, but it's definitely a big topic that we're keeping our eyes on.

POC: Yeah, yeah, yeah. I could imagine. Almost certainly, if you with farm, if companies are changing their supply chain. Potentially as a result of a geopolitical issue and moving from China. Yeah, certainly will keep you busy, I would have thought that [crosstalk 00:32:05]. Maybe just finally, be interested to understand, given all the volatility in markets as a result of the current economic crisis we're going through, how has ESG positioning in your portfolios changed? Has it impacted negatively and positively on any of the companies you're holding?

MCS: Not a great deal, to be honest, I think the same drivers that were there before the crisis are still there in terms of ESG drivers. We're still seeing climate change as a big theme and that's not going to go away. We see increased human rights focus. We're seeing more war on waste, et cetera. And as we saw in the mini AGM season, which was quite recent, we saw some big votes for shareholder resolutions on climate change.

From an investor perspective, the pressure on ESG hasn't really gone away. And in a crisis like this, I look at a company, I think, well, what is ESG research really doing? Well, it's assessing a company how well it's responding to challenges in the external environment, whether those drivers are ESG or not. We think companies that are more adaptable are the ones that have strong ESG profiles. And we think that those companies will ultimately fare better in this environment.

And if you look at the broader industry, ESG funds have had a quite a lot of inflows in both 2019, and also in 2020 to date. And the performance of ESG funds have generated, performed quite well, as well. That's been a trend for some time, but it's been accelerating in 2020. And yeah, like I mentioned before, in the COVID-19 environment, we just think incumbents that have strong ESG profiles should be performing better than others.

Because it comes down to things like being able to provide for flexible working. Many of the companies where we invest in, they were doing that before the crisis came in. And now, they're benefiting from that. Companies that have strong supply relationships, they also benefit from it.

Yeah. No, I was going to say there, Mans, that yeah, I think with all the whole workplace environment's been challenged over the last three months. And we've all, I guess we've all been surprised on our Netwealth that at one stage we had most of our staff working from home. And I don't think we actually believe we could have achieved that previously.

POC: Yeah, there's going to be all sorts of different behaviours and slight changes to behaviours as a result of COVID-19. Yeah, it's interesting. We usually finish our podcast, Mans, with asking guests for any personal investing tips that you've applied in your own life and really central to your own investment philosophy. Have you got any one or two tips you might be able to share with our listeners?

MCS: Yes. I guess I would have to put on ESG slant on this question. But I think it really comes down to something I said initially, which is, you need to look at the very business model that the company has. And it might sound like a cliche, but I really believe that if a business model relies on not paying for the true labour costs or the true environmental costs, it's ultimately flawed in the long-term. It might work in the short-term, but in the longer term, you will see a regulatory change. And at that point, current earnings will not be sustainable. That will be the one tip I would give on that.

POC: Yeah, yeah. It's interesting. And I guess, again, a discussion this afternoon just keeps going back to the company management and the way they actually look at society and these ESG trends and whether it's climate change or human rights. But no, Mans, it's been a fascinating discussion, so thank you very much. And I think you've certainly highlighted that ESG investing is not simple and it takes a lot of actual research and resourcing invested by the manager there. We're very appreciative of your time this afternoon. Thank you, Mans.

MCS: Thank you very much.