Author: Holly Nahar

Integrating Environmental, Social, and Governance factors into the analysis of equity securities is picking up steam in markets today. The influx of capital into funds that integrate ESG factors and the growing widespread availability of research that supports the greater return component is encouraging more and more investors to practice ESG integration.

There is a range of techniques available to asset managers and institutional investors and these techniques may not focus on every issue that a company may be involved in. There are different facets of the ESG integration model that may pose materiality concerns to stakeholders, that may be different to asset managers and institutional investors.

A look into the Quantitative and Active Ownership Integration Approach:

The Quantitative analysis focuses on financial forecasting and economic analysis. In this integration strategy, firms assess the impact of ESG factors on the economy to adjust forecasted economic growth rates and apply them to company financials. The firm then identifies ESG material factors for a sector that poses financial risks and integrates them into valuations to properly provide investment recommendations of companies.

AJF Capital Management had the pleasure of speaking with Sterling Capital about their ESG approach. The conversation surrounded an equity holding and its environmental violations. As investors with Sterling Capital’s Sustainably screened fund, it was alarming that one of its energy holdings dumped toxic chemicals into San Pablo Bay from its Rodeo Refinery. After being aware of the $11.5 million fine we reached out to Sterling Capital to understand why they’ve continued to hold this company in their portfolios.

At the firm level, Sterling’s strategic plan includes databases that evaluate sustainable companies that have strong environmental, social, and governance characteristics as well as outstanding financial performance. Sterling Capital has chosen to evaluate companies based on the impact on portfolio prospective performance and risks that ESG factors might pose that are material and quantifiable. Because of the metrics used and their investment decision process, Sterling decided that this energy company is an investment-grade company. This meant- because the violations were below a certain percentage of net income, the issue did not matter, leaving them unaware.

This was problematic for AJF Capital Management. At AJF Capital Management we believe that controversial non- financial material issues should be addressed regardless of a monetary materiality threshold. We believe in Active ownership and as such, company engagement was essential.

In this scenario, we took into account the communities affected and how it impacts their quality of life. In Sterling’s “common sense” approach, the only thing that mattered was the overall controversial topic impact on the company’s bottom line. AJF Capital Managements’ approach did not neglect financial performance, we’ve factored in the potential effect on future cash flow if these violations continued to occur. We assessed litigation fees, reputational damage as well as company strategy.

In the Quantitative Approach, Sterling Capital chose to pay attention to the financial materiality of the investor. In AJF’s Active Ownership approach we chose to look at the materiality to the investor as well as all Stakeholders, which includes the community, the employees, and the company. Too often we have found that where there is smoke there is fire and the use of our common sense is that these issues should be revealed and addressed rather than concealed or ignored.

While both approaches take into account ESG criteria they each have a different outcome. The Sole focus on Financial Materiality ignores the stakeholders and focuses on the bottom-line financial number. Ignoring material non-financial factors could ultimately lead to larger issues that may eventually hurt the bottom line, and there is much precedence to point (i.e. BP safety track record prior to Deepwater Horizon).  On the other hand, engaging on material effects on communities that have to live with the negligent behavior of large corporations could ultimately benefit all stakeholders. In this scenario, everyone wins. Corporations and stakeholders will thrive when the entire picture is considered. We are curious, however, to see what your thoughts are about whether asset managers and institutional investors should take into account both the Qualitative and Quantitative ESG approach and whether engagement should occur at the company level.

Any opinions expressed in this forum are not the opinion or view of American Portfolios Financial Services, Inc. (APFS) or American Portfolios Advisors, Inc.(APA) and have not been reviewed by the firm for completeness or accuracy. These opinions are subject to change at any time without notice. Any comments or postings are provided for informational purposes only and do not constitute an offer or a recommendation to buy or sell securities or other financial instruments. Readers should conduct their own review and exercise judgment prior to investing. Investments are not guaranteed, involve risk and may result in a loss of principal. Past performance does not guarantee future results.

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