special report:ESG
Investors develop elaborate tools to identify the most socially responsible companies and avoid the ones that aren’t
By Charles Newbery
In January, a dam suddenly collapsed in Brazil, killing 248 people as a wave of iron ore waste swept the countryside. The disaster came as a surprise to many investors in Vale, the mining company that operated the dam. But not all. “We knew that something could happen,†says Carolina Rocha, COO of Perfin, an investment management company in São Paulo.
Another of Vale’s dams had given way in 2015, a sign that something was not right. In response, Perfin cut the weight of Vale in its fund to 3% (the fund traditionally assigns a weight of 10% to 20% to favorite shares), containing its losses when Vale’s shares tumbled 25% in the two days after the second disaster.
A small but growing number of funds managers in Latin America are digging deeper into environmental, social and governance (ESG) issues to try and gauge what could affect financial performance. Forty-two of them, most in Brazil, have signed the United Nations Principles of Responsible Investment, which globally has 2,500 signatories representing $86 trillion in assets under management. They use these principles to help pick companies that not only achieve non-financial goals but make a favorable return.
A growing body of research shows that ESG strategies improve financial performance — and in turn share prices. Oxford University and London-based investment management firm Arabesque Partners found that “companies with robust sustainability practices demonstrate better operational performance, which ultimately translates into cash flows.†Through July 2019, the MSCI Emerging Markets (EM) ESG Leaders Index posted a 180% return compared with 119% by a comparable index without ESG factors.
While numerous organizations grade large, mainstream global companies—some even creating investible indexes of ESG-approved stocks or bonds—few Latin American companies are vetted. So it’s often up to responsible investors to do their own research.
ESG grading of companies often uses a scale from 1 to 6, with rating factors ranging from water use to carbon emissions, labor incidents, workplace diversity, treatment of suppliers, community relations, and the makeup of the board of directors. Daniel Utsch, equity portfolio manager at Banco Fator in São Paulo, says he screens companies using 28 ESG criteria — other fund managers do more, some less — and then grades them from a base of zero to determine the fair value of the stock, at up to minus 5% or plus 5%, depending on the performance. A stock trading at $20 with the worst ESG grade, for example, would have a fair value price of $19.
The research takes time. But the payoff, he says, is key to knowing when to buy, sell, or avoid a stock. If a company is lax in sanitation, for example, that could signal future problems such as a recent tainted meat scandal that hit the Brazilian meatpackers BRF and JBS, he says.
Maribel Monterrubio, director general of Vitalis, an independent investment advisor in Mexico City, says ESG analysis “helps us to have a much deeper understanding of the company because you really look at its essence, how the company is formed in terms of more fundamental issues.â€
Fabio Alperowitch, fund manager at FAMA in São Paulo, says ESG helps him determine if companies are preparing for future trends instead of focusing only on short-term margins.
He says, for example, that Brazil’s truck engine maker Tupy has yet to consider the impact of a growing demand for cleaner transport and electric motors on its business, putting future sales growth at risk. Tupy did not respond with a comment.
FAMA also has pulled out of meatpackers, which Alperowitch expects to face a decline in sales as consumers turn to plant-based protein. Indeed, Brazil’s Marfrig Global Foods, one of the world’s biggest beef producers, in August teamed up with US-based Archer Daniels Midland (ADM) to start producing and selling 100% vegetable protein-based burgers in Brazil. “We want to give consumers the power of choice,†Eduardo Miron, Marfrig’s CEO, said in a statement.
Alperowitch likes Klabin, a maker of paper packaging, which he expects to benefit from rising demand for alternatives to plastics. Ditto for M. Dias Branco, which buys only cage-free eggs to make its line of cookies and pastas, reflecting a growing consumer bias for animal-friendly products.
“Brand awareness in the future depends on what the company is doing today,†Alperowitch says.
Responsible investment, however, is still far from becoming as mainstream in Latin America as it is in Europe and the US, says Renato Eid Tucci, portfolio manager at Itaú Asset Management in Brazil. Morningstar found in a survey this year that three quarters of US investment funds offer strategies that use ESG, driven by demand from younger clients.
There are challenges when it comes to convincing investors of ESG benefits in Latin America. And while companies have been putting more effort into responsible actions, they are still weighed down by pressing issues like stemming losses and renegotiating debts in sluggish economies like Brazil.
And given the relative size of the investment pool in Latin America (the region has 1,180 listed companies, far less than the 7,740 in North America, according to data from the World Bank), fund managers have to be flexible on ESG factors, especially when calculating in the low liquidity of many companies.
Another limit is a lack of information for analysis. Most companies publish the makeup of their boards and executive teams, making it relatively easy to gauge their diversity. Environmental and social factors are harder to follow, in part because companies tend to “give you the perfect answer almost every time†when asked about these issues, Ustch says.
Fund managers talk with as many sources as they can — customers, suppliers, middle management, employees, consultants, competitors— to get a broader picture than just speaking with senior executives, says Alperowitch. “I have never had a CEO tell me that their strategy is bad,†he says. “They are always optimistic about the future.â€
Another strategy is for fund managers to engage companies on how ESG issues can impact their business and what they can do about it. “They are receptive,†Eid Tucci says. “They are aware that our society is responding to this input.â€
Indeed, Vale says it plans to invest 11 billion reais ($2.7 billion) to increase its dry iron ore processing capacity to 70% in 2023 from 60% this year, reducing the need for dams like the two that collapsed. Dry processing also boosts productivity and reduces power consumption, according to the company.
Vitalis’ Monterrubio says investors, like consumers, must play a role in driving sustainable improvements in corporations. Companies won’t do it “just because,†she says. “We need to put capital in those companies that are trying to resolve the world’s major problems. It is a social need. When the market has this vision, then companies won’t have any other option than to get on board.â€
Perfin’s Rocha is already seeing a trend toward more corporate responsibility.“In time, this is going to be major,†she says. “If you are not paying attention to this right now, you are going to be out of the game in the future.â€
