The Impact of Governance and Social Factors on Portfolio Construction
Man: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.
Lauren Bienemann: Welcome everyone. Thank you for taking the time to join us today. My name is Lauren Bienemann and I am a client advisor on the Institutional Defined Contribution team here at JPMorgan Asset Management.
And today I am thrilled to be joined by Jennifer Wu, our Global Head of Sustainable Investing; and Leon Eidelman, Emerging Markets and Asia Pacific Equities Portfolio Manager to discuss many topics top-of-mind for investors from ESG in a COVID-19 world to ESG in an investors’ portfolio. We’re very lucky to have them both on today.
For some background on their role as Head of Sustainable Investing for JPMorgan Asset Management, Jennifer is responsible for leading the effort of creating innovative investment solutions using ESG factors to deliver both purpose and performance to the clients in their portfolios.
Leon is a portfolio manager within the emerging markets in Asia Pacific Equities team and is responsible for fundamental bottom-up portfolios including gem discovery and GEM Focused strategy. Jennifer and Leon, thank you for joining me.
Leon Eidelman: Thanks for having us.
Jennifer Wu: Thank you.
Lauren Bienemann: Over the next 30 minutes or so I will post several questions to both Jennifer and Leon. So with that, let’s get started.
Jennifer, let’s begin the conversation with you. ESG is top of mind for many of those dialed in today. I know I’ve had more ESG conversations over the last four months than I’ve had in the last 10 years.
But it can also be a confusing topic. How do you explain what it is and what it’s trying to achieve when speaking to clients?
Jennifer Wu: Yes, thank you Lauren. Indeed, ESG is top of mind for us as investors. But you know, that’s not actually all. It is also top of mind for corporates. And why is that? Well, the way we think about ESG is that it is actually a collection of factors that are not traditional.
It’s a collection of factors that are closely related to the input and output of a business operation. We see ESG as factors that we use to measure the sustainability of a company. And why do we think that it’s important? Because more and more, we’re actually seeing how a company financial performance is now being impacted by its sustainability performance.
So, let me give you some examples. If we look at the E of ESG first and E means environmental. So, from an input perspective, this can be about where does a company source its electricity from, how efficient it is in consuming electricity.
And if the cost of electricity goes down as a result of switching to say a renewable power source or the cost of electricity actually goes down because the company decides to install LED lights and that is more energy efficient, that’s actually good for the bottom line.
So that’s what we meant by, you know, looking at the inputs of a company’s operation in the context of the E of ESG. And from an output perspective, we could also be looking at different things, for example, how wastewater is being treated. And it’s important because if it’s not properly dealt with, a company could be fine and suffer financial losses.
So, metrics such as energy consumption or wastewater management are not your typical metrics that you can find in say like financial statements. However, they are very important from a financial impact perspective. And if we look at the S, which means social, it generally covers what we call stakeholders and that includes customers, employees, suppliers and community.
The most important inputs of a business operation in today’s world is actually labor. So, a company’s ability to attract and promote talent is key to its financial success as we all know. And we look at labor management, compensation benefits, and also diversity and inclusion for that reason.
From an output perspective, how is the company treating its customers through the provision of products and services? It’s toy company, for example, product safety is of paramount importance because if it’s not dealt with seriously, it could hurt children, which may result in litigation fine, and even reputational damages.
So in our view, a company’s relationship with its stakeholders really key to its financial success and it actually gives the company the license to operate. And the last part of ESG, which is the G, and it means governance. The way I think about G is that it’s actually the foundation of all things.
So it’s about the foundational structure of a company. As you could imagine, in that regard typical G issues include things like long-term capital allocation strategy, tax evasion, business ethics, board effectiveness and independence. These are all critical issues not for more reasons but they are key ingredients for a company to be successful.
So in a nutshell, like, ESG are different factors that impact the sustainability of a company and a company’s ability to generate consistent and repeatable return. And if you look at it through the lens of input and output, what you will find is that the ESG factors that matter to each company can actually be quite different because of its specific business models as well as the industry that it’s in or even the country that it’s in.
So, using ESG in investing is to have a more comprehensive assessment of all the risks and opportunities that a business operation faces. And then we make an investment decision with a goal to deliver better risk-adjusted return. And that’s what we regard at JPMorgan as integrating ESG factors into investment is all about.
Lauren Bienemann: Thank you, Jennifer. That reminds me of the call that we had last week when we had sustainability, we're talking about sustainable investing. That’s fully informed investing. So, thank you for that.
Leon, shifting over to you. Can you talk a little bit about what you’re seeing across the emerging markets equity universe and the importance of ESG factors in your portfolio decision-making?
Leon Eidelman: Sure. I mean, I think from a client perspective, there’s been an interest in ESG for many years. I think the main difference that I perceive is that this has really become much more important to North American-based investors over the course of the last year or two, whereas certainly there are parts of Europe where this had been incredibly important to clients for longer than that.
So from that perspective, I think we’ve been speaking to clients about this for a long time now. And where it’s relatively easy for us to do is simply because we explain to all of our clients that the way that we think about ESG is inextricably linked to the way that we think about investing.
In that everything that we do from an investment perspective is to set out our views of where business businesses will be over the very long-term. And clearly, the longer you think about the investment horizon for a business, the more important ESG factors become.
And that ultimately the way that a business deals with all stakeholders involved is going to have a direct bearing of how long that business will be around for. And so again, from an investment perspective, ESG is something that we have integrated into our investment framework and have had integrated into our investment framework for over a decade now.
We really haven’t had to change anything to bring ESG and make it front and center. But we have obviously taken the opportunity to as Jennifer said, you know, welcome the fact that companies themselves have recognized that this is an incredibly important part of what they do to sharpen the tools with which we can determine who’s doing a good job, who isn’t.
And what the right metrics should be, who is best-in-class and how we can potentially engage with those that aren’t to bring them down the line. So, again from an investment perspective, this has been there for a very long time. From an engagement perspective, I think that we’re doing a lot more.
And then from a tools perspective, again because there’s that much more information available, I think that we have done a good job in bringing in all of the potential bits of information that could help us make better decisions around how these topics could impact again those businesses over the very long-term.
Lauren Bienemann: Thank you Leon. Jennifer back to you. Given COVID-19, a lot has changed about the way we operate on a day-to-day basis. Jennifer, how's the virus accelerated the ESG agenda and brought it even more to the forefront than it was before?
Jennifer Wu: So, the virus, the pandemic, it has really made the ESG agenda more important than ever before in our views. But there’s one thing that we’ve learned from this crisis, it has to be that we must be better prepare for the next crisis. And, you know, what we have seen in the last few months is that companies that had had placed ESG considerations.
So, as I mentioned earlier, it’s not just on top of mind for investors before a lot of companies for quite some time already. So, companies who have had placed ESG as part of their business strategy are proven to be much more resilient.
We saw how companies that have focused on the S of ESG, by always putting employee first, they were able to do a much better job at ensuring that there is good support in place to help their workforce. We also saw how companies that has focused on good capital allocation strategy, they were better equipped to deal with liquidity crisis.
And this has become very prominent in say, Leon’s world, for example. And that’s why it’s not surprising to see how even in a well-diversified portfolio, companies with better ESG profile have performed well. And we must recognize that, at the end of the day, we are very closely linked to nature and we’re very closely linked to one another.
Sustainability issues such as climate change, social inequalities, they’re not some separate problems that we as investors or those in the business world don’t have to worry about.
A very important key takeaway from this pandemic I hope is that businesses can sometimes be the cause of these environmental and social problems, which could in turn make these companies growth unsustainable. At the same time, we also see how some companies are actually providers of solutions to these problems.
So, when it comes to asset allocation and investment decisions, obviously we want to avoid those risks. And we also want to be able to tap into these new investment opportunities. Everything is interlinked and that’s really what ESG can give you.
A more thoughtful and comprehensive way of analyzing the situation, be it during normal times or in a pandemic like this. And also use that as a way to deliver a more forward-looking approach when it comes to investing.
Lauren Bienemann: Thank you Jennifer. Speaking of COVID-19, how that’s impacted ESG. Both Jennifer or Leon, I post this question to both of you. How did ESG perform during COVID-19? What are some of the lessons that we’ve learned? Plan sponsor or fiduciary performance is something that they always consider. So, what have we learned during this crisis?
Leon Eidelman: Oh, just chime in here. In a way, it’s a confirmation of what we expected in the businesses that have management that have taken these issues seriously. We’re able to respond to the threat and do the right thing and for me I think by giving examples, we can kind of get that point across.
You’ve got companies like Young China, for example, going out of their way to extend healthcare coverage for their employees to make sure that their employees felt comfortable. And in fact going kind of way beyond what other Chinese companies have been doing in terms of covering other members of the household when they didn’t have to.
And ultimately that just improves the way that employees feel about the company. It has meant that they have had no issues bringing employees back to the restaurants to get them back open. And it has meant that they have in fact been able to get back to pre-COVID type occupancy levels and restaurant levels faster than anybody else.
And I think at the end of the day, a company is like an ecosystem and a very big part of that is driven by your own employees. And so operationally you’ve had, again, businesses that have been able to rise to the challenge and have been better businesses that were not prepared that did not have the right structures in place have suffered.
So I think, again, ultimately this just reflects the fact that the right management’s recognize that they need to invest in ESG-related topics because ultimately that’s what extended their own duration. This was pretty much a trial by file.
But the best companies kind of rose to that occasion and it’s visible for that stock price terms, it's visible in operational terms.
Jennifer Wu: Yes. I will echo what Leon just said. I think if you really bring it back to looking at in a business operation, right? You look at input and output. Companies who have been thinking about how to operate in a more energy-efficient way or, you know, who’s been to Leon’s point taking care of its employees and customers, they have been able to perform better and they have proven to be more resilient.
So, I think the lesson learned here is that these issues are going to be even more important not because of one crisis but as a matter of fact, I think this crisis has shown how it is very important to when you make investment decisions and decide whom to invest in that.
You are picking companies that are thinking about the most optimal way of doing business and also are taking care of all the stakeholders that are involved because these are the kind of companies that could actually generate long-term and repeatable financial return. And that’s what you’re looking for.
So I think ESG as an agenda is more important than ever before. Many thanks to this pandemic in a way because it serves as a good reminder of how resiliency is actually very important and there are lots of issues you need to take into consideration when you run a business beyond what’s out there on the balance sheet.
Lauren Bienemann: Absolutely, I believe we can all agree that 2020 has been extremely enlightening in how businesses are run. We also recently released a white paper on the impact of governance and social factors on portfolio construction.
Jennifer and Leon, I’d like to get both of your opinions on my next question. How can these factors influence portfolios, objectives and returns?
Jennifer Wu: Maybe I can take this one first. So Lauren, you touched upon a very important word here, objective. One of the things that gets investors sometimes very confused about ESG is really around whether ESG equals to exclusions or whether ESG requires you to sacrifice return.
In reality, the answer is yes and no. And why is that? Because it really depends on what the objective is. So, like I mentioned earlier, ESG by definition is a collection of E, S and G factors. And they are information that an investor can use to best align with his or her objectives.
So, if I look at how we do it at JPMorgan Asset Management for all of our funds, and I’m not just talking about sustainable fund, but all of our funds. Our portfolio managers explicitly consider social and governance factors in such a way that it can add values.
What it means is that when we look at these factors, we focus on the ones that are financially material because our objective is to use ESG as an additional input in our investment process to create better risk-adjusted return. And this is what we call traditional investing that’s ESG integrated. There is another type of objective if you like.
So separately, we also have a dedicated sustainable strategies. And in those, the way we think about ESG and how we use ESG is that we have a defined set of sustainable objectives that will prevent us from investing in certain companies or sectors.
And the objective of these funds are not just about making financial return. Some of these objectives are not necessarily purely based on financial materiality. So here, we use ESG to identify those companies and sectors for either exclusionary or inclusionary investing. So, an example could be if the objective is to promote better access to education.
We would only invest in companies that provide goods and services that can enable better access to education. And in this instance, we will be looking at a S factor and focus on the output of a company to identify those who actually provide goods and services enable its customers to gain access to education.
So, because it’s not driven by financial materiality, return is actually secondary. So, this is a different way of using ESG in investment strategy whereby you actually have dual objectives. So, in a nutshell, I think you touch upon a very important point because objectives are directly linked to return.
Just very, very important to understand what it is that you’re trying to achieve and then we can show you ways on how you can best use ESG to achieve that.
Leon Eidelman: I’ll chip in here. I mean, I think from my perspective, this is an important one because there’s more resistance to it in North America as well. But every time the topic comes up, I think that people start to think that you can’t get something for free, right?
You have to give something up to be, you know, on the ESG done by in order to be a sustainable. And I just can’t subscribe to that because ultimately, if what you’re looking to achieve is to identify businesses that believe have the ability to be much larger over time, then a key component of that is the assessment of whether that business will be around and in what state and whether its existing fundamentals are not sustainable but sustainable on that.
There is something that you can comfortably predict into the future. And so ultimately there’s no way to differentiate between taking a long-term view around the quality franchise and making an assessment around the ESG qualifications.
There’s been some studies, notably a recent one from Harvard making the case that companies with very good ESG qualifications tend to trade at a premium multiple to the market.
And again, if you kind of roll back on what does that mean, it means investors are willing to pay a higher multiple of earnings i.e. mean more years into the future for a business with good qualifications. To me that’s quite simply a confirmation of the fact that then tells you that there is more confidence with which you can predict the fact that those earnings will be around well into the future.
So, the market itself is also telling you that businesses that satisfy this criteria correctly are worth more. As an investor, I’m looking for businesses that will be worth more. So clearly, these two things, the goal of a portfolio and the way that a business deals with all stakeholders, these are kind of one of the same thing really.
Lauren Bienemann: Leon, clearly ESG practices are something that you take into consideration when making investment decisions. But how are you and your team thinking about ways to improve how we evaluate ESG and incorporate it into our research?
Leon Eidelman: Yes. So, like I said, just kind of started off as qualitatively discussing the topics around how we assess a business. Then we went into what we call the risk profile, which was 98 questions about business of which maybe two thirds were environmental and governance-related.
And we’ve kind of taken it a step further where we have our solver analysts to go through a process which we call our materiality framework. And within this, we’ve effectively broken up our universe into industry subgroups where every single industry subgroup is a little bit different.
I mean, you know, an energy company is going to have very different ESG type priorities than, for example, a retail company. And so, by looking at those 54 sub industries, you can have much better assessment of where materiality issues are similar.
At the end of the day, by having our analysts go through this, we end up moving ourselves away from using external data, which we find to be wholly unreliable. And again, we can use the judgment that those analysts have around what matters for a business and, you know, how that business is engaging to have a better understanding of how those businesses are working.
And ultimately that’s going to have an impact on how we value those businesses and how we assess that businesses duration. So, by going through this process, we also have an idea of who is best-in-class and who isn’t. And that then also enables us to engage with companies directly.
If we have a company who is clearly carrying the banner on a particular topic, well, the next time we need a company that isn’t we can say, “Well look, you know, look at what these guys are doing. Look at how they address this issue and look at how the market is and rewarding them or how they’re able to do a better job.”
You know, this is something that you should be going towards. It allows you to understand very quickly when, you know, you come across a business that isn’t actually doing a good enough job in your mind, business is just worth that much less.
So, in terms of our understanding about a business and again, the accuracy with which we can forecast where that business qualitative, for good stock prices, where that business will be four or five years down the line. It’s just made us that much sharper on that assessment.
Lauren Bienemann: And you talk a lot about active engagement and as a fundamental bottom of investor, you spend a significant amount of time meeting with the management of emerging markets businesses. What are your thoughts on the role that engagement complaint actually improving ESG practices?
Leon Eidelman: Yes, I mean, I think it’s incredibly important. I think the main change that I perceive here is that you go back five years, company’s kind of paid lip service to ESG. But, you know, the person in charge of ESG might have been kind of in some sort of back office writing a report that eventually got shared with the board and not taken seriously.
And now, I think, again if you’re the chief executive of the business, you are immediately aligned towards extending the duration of your business. And you recognize that the person who is responsible for your business’s adherence to ESG is incredibly important. Then ESG is given prominence in annual reports and prominence in board meetings and prominence on the CEOs agenda, which means that by extension when we engage, this is a topic which goes to the top of the house.
And it’s a topic, which is ultimately incredibly important to the way that those executives themselves are going to be judged. And so, we find that they’re incredibly receptive.
I think that we are in an incredibly privileged position to be able to engage, simply because we have more analysts than more people on the ground and see more companies than most others. You know, the emerging market Asia Pacific team there's something like 5000 company meetings a year.
You know, we’ve got nearly 45 analysts who are dedicated to covering these companies who can be a source of information to the companies with which they’re engaging. To my point, if you can say, “Well, you know, you ran pretty poorly here, this is what the best-in-class is doing.” Well, nobody’s going to refuse good information, right?
So, they’re getting a much more receptive experience from the corporates with which they’re dealing with. And I think ultimately, from the positive side, I think that we are also able to see positive change in companies. Oh yes that makes a lot of sense. Let me get back to you.
And then, the next thing, you know, it’s in their annual report and it’s been an important topic that they’ve brought in. And so, we really tried to address all sorts of topics from E to S, the G, that kind of runs the gamut. It’s things like, you know, how much water waste goes into making a liter of beer to understanding how well employees in textile factories in Southeast Asia and China are being treated.
You know, we kind of run the gamut in terms of the types of topics that we would cover with corporates.
Lauren Bienemann: Well, that is quite active engagement. And that leads me to another topic that’s been coming up in a lot of my client conversations. Jennifer, active management in the context of ESG, can you give us your take on this?
Jennifer Wu: Yes, sure Lauren. So, I already spoke a lot about how ESG factors can be very different depending on a company’s business model, right? And the industry that it’s in as well as the location of the business operations. So, what this means is there is no one-size-fits-all when it comes to ESG.
And to be able to do this well, we need a very good understanding of the individual company in the sector in order to be able to discern what E, S and G factors are most relevant. So, it’s not possible to have one way of calculating ESG risk and apply to all companies in the same way.
And if you think about it, investing is really about making a prediction of the future. And it’s not possible to make a good prediction by only just looking at historical data published by companies, for example. So, you know, a company may have suffered from cyberattacks in the past.
And if we only rely on backward looking public data such as numbers of attacks, we will assume that this company faces great risks and customer data privacy, which is an ESG issue. So, it’s usually categorized as an S issue, by the way. And this is the way that many third party ESG data vendors would do.
So in that sense, we will probably give this company a bad S score. However, past attacks don’t necessarily mean that the company will face similar level risk in the future. So what we do with active ESG research is that we can identify companies that have learned the lessons from the past and have put in measures to better manage such future risks.
And this type of information is not necessarily disclosed anywhere and sometimes it could be really qualitative. So to me, this is when an active research and investment management process can really differ, because we can capture this type of forward-looking information from our interactions with the companies as well as our additional due diligence that we do.
And it’s not possible to do that without analysts on the ground, like Leon said, who actually know the company really well has the ability to influence company and can continue to track progress, right? So, engagement together with active research and active investment management are inseparable in my view and that’s what you need.
And what’s also needed is domain knowledge and expertise in sustainability issues. A lot about ESG is still evolving. For example, translating climate change science into investable solutions is not always straightforward. And also the implications can be very different from sector to sector. So, the way of how some of these ESG factors are constructed can also be outdated.
For example, one forward-looking way of identifying potential controversies is to scrape through news and social media. However, most of these signals or factors are built based upon number of hits.
And if I look at the recent scandal in Germany with the online payment company Wirecard, most controversies related scores provided by a third party ESG data vendors actually looked pretty good before the scandal because there hadn’t been a lot of coverage in the press or social media, except for the report from Financial Times.
So, does that actually mean that one opinion should matter more than the others and how do we even determine that? One of the things that we know for sure from this is that by just looking at the number of hits is not enough. There has to be a better way than just looking at this.
And this is a real example of some of the research that we on the sustainable investing research team are doing now together with the sector analysts, going deep into individual companies really understanding what are the ESG issues that matter and also be able to identify ways to predict what is likely going to happen.
So, all in all ESG research is active, it’s dynamic and it’s not a one-size-fits-all approach and it cannot be purely based on historical data. So this is why I think active research and active investment management are required to really make ESG useful.
Lauren Bienemann: Jennifer, one more for you. Given the state of the world, company’s diversity and inclusion efforts have been brought to the forefront. How do you view how our firm and how other firms should approach this, particularly from an investment standpoint?
Jennifer Wu: Well, Lauren, thank you so much for bringing this up because it’s really very important and it’s a financial internal issue. Earlier this year, we published our JPMorgan Asset Management global investment stewardship priorities. One of those is around stakeholder management and specifically focusing on diversity and inclusion.
What we have seen from the past few months is that not only diversity and inclusion is important during normal times, but in times like now, diversity and inclusion is more important. Because to solve for a crisis like this and to be able to react in the most appropriate manner, you need diversity and thoughts and you need an inclusive environment to get everyone working together.
What we have found is that a more diverse and inclusive workforce tends to have greater empathy, which really helps to bring people together and make companies more resilient. And this is why it’s part of our five global investment stewardship priorities because we don’t believe that from an investment standpoint, a company can be successful for the long run without focusing on diversity and inclusion.
Lauren Bienemann: Thank you, Leon and Jennifer.
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