Valuation, margins of safety and accounting analysis can have an important role in the ESG process, as our Global Equities team demonstrates.
In this series of blog posts, we dive into the strategy and daily life of Evli’s Global Equities team. The Global Equities team invests in underpriced companies that generate cash flow and have strong debt coverage.
In the Global Equities team, our investment approach rests on concepts such as the basic valuation equation in finance, margins of safety and accounting analysis. All of these methods can be applied to incorporate environmental, social and governance (ESG) issues – or are directly linked to them.
The basic valuation equation states that value equals expected discounted payoff. Therefore, ESG opportunities and risks should be reflected in either the projected future cash flows in the nominator or in the discount rate used to capitalize them, i.e., in the denominator of the equation.
For example, ESG related risks could reduce expected future cash flows or increase the risk premium used in discounting them. Technically, that’s all there is to it, it’s that simple.
In management we trust?
The first step in valuation is asking whether we can trust the data. The fancy term for this is governance analysis.
Management must be transparent in their reporting to owners, both during good times and bad. Being transparent means reporting essential information the public needs to understand the business with all its material risks and to value the company.
Unclear reporting, such as complicated explanations or contradicting text and numbers could indicate that management is trying to hide something. If a company has been communicating openly but suddenly changes its style and becomes less transparent, this should raise a red flag.
Our Global Equities team is critical of accounting methods and monitors forensic accounting ratios to spot areas requiring special attention. We want to understand potential auditor concerns, reporting and recognition principles, restatements, special charges, consolidation practices, ownership structure, and so on.
We focus our analysis on facts and relevant details, not on sweet talk. In some ways, company materials can resemble advertisements. The glossy portion of the ad is devoted to reasons why you need an amazing product while the small print depicts the pain that may await if you use it.
Here’s an example that illustrates the governance pillar of our approach: Our research process uncovered, early on, accounting and ownership structure risks in US listed Chinese variable interest entities (VIEs).
China’s legislation restricts foreign investments in strategically sensitive industries, and many capital-hungry Chinese companies have circumvented these restrictions by offering VIE based ownership structures to foreign investors. An example of such a structure could be a case where foreign investors’ rights are based on depositary receipts of a US listed offshore domiciled shell company, and the shell company’s ownership of the actual Chinese business is arranged through contracts, not direct equity ownership. So far, Chinese authorities haven’t taken a clear stance on VIEs. Therefore, foreign investors’ ownership rights in the underlying Chinese businesses may be on an unstable footing. After some research – and until more clarity on the issue is available – we rule out investment cases that rely on Chinese VIE structures.
Our governance analysis is based on independent thinking, not on copying others or using external ratings. We use methods consistent with our investment strategy and our mandate to produce a risk-adjusted excess return, even at the risk of sometimes appearing unconventional to the outside observer.
Focus on potential risks
Objective tests of ESG leadership are still far from scientific. If corporate ESG is to be understood as the product of action and intent, then observing and measuring it is very challenging.
The basic valuation equation is about payoffs and discount rates, and cash flows are one way of capturing all these effects instead of using more indirect ESG metrics that can be difficult to find, difficult to interpret, and cumbersome to convert into financial values.
In many cases, the investor must rely on an ESG reputation or rating which may or may not be deserved. Quality of management and corporate social responsibility involve the same basic difficulty: it is impossible to judge how far they may properly reflect themselves in future cash flows or the current price of a given security.
We have therefore chosen not to discount any positive scenarios in our valuation but focus on potential risks. This is how we approach “traditional” economic and financial analysis as well, so it seems only logical to apply the same standards to ESG.
First, we assume that historical ESG cash flows, as reflected in the historical analysis, allow, if not a conclusive, at least a reasonable basis for measuring their future impact. Second, in order to further contain risks, we include a Margin of Safety into our typical free cash flow projection. This functions as protection against future “ESG disappointments”. Third, we integrate future ESG related cash outflows that are material, probable and quantifiable.
Fortunately for us, these are exactly the ESG risks company management must evaluate in reports, so we get the information for free and without any need to speculate, provided that our Governance pillar has indicated that management is trustworthy in the first place.
History as a first approximation
Historical analysis of a company’s business record is an essential step in the valuation process, as it reveals information about past corporate performance and behavior.
In finance, the future is largely unpredictable, and research must often be done assuming that the past offers at least an approximate guide to the future. The more debatable this assumption, the less valuable the analysis, and therefore this approach is more appropriate when applied to established businesses than to start-ups or those subject to large economic gyrations. We, therefore, emphasize established companies with good historical cash flows.
Our view is that a good historical business record offers better future business prospects than a poor track record, at least on a diversified group basis. The reason is that future cash flows are not determined only by good luck or by management skill, but the capital, experience, employees, stakeholder relations, trade contacts, reputation, and all other factors (including material ESG factors) that contributed to good historical cash flows will exert impact upon future cash flows.
Moreover, if a company has generated strong fundamentals over prolonged time periods, it is more probable that the company has honored the implicit and explicit contracts with all its various stakeholders, or otherwise the status quo would have been disturbed. Exploiting stakeholders, while possibly beneficial for short-term profit, is likely to result in ex-post settling by these or other stakeholders in a manner that ultimately harms long-term cash flows.
To illustrate this, consider a company that has faced allegations of bribery (Governance) and of anti-union activities (Social) during past years and continues to face them today. The company has increased hourly wages and other benefits to reduce discontent among the workforce and spent considerable amounts of money on internal investigations and enhancing anti-corruption compliance.
The ESG costs and possible litigation settlements, penalties or fines will show up in historical cash flows. Other negative externalities may also turn into unanticipated cash outflows in the long term: for example, anti-union practices may have resulted in reputational damage, production delays due to labor unrest, loss of growth opportunities, high employee turnover and so on.
The bottom line is that these actions and costs (benefits) materialize at least partly as past cash flows (if the research window is long enough), which in turn influences projected future cash flows.
Past cash flows contain information about the most material and systematic issues a company has faced, and in many cases, it is not unreasonable to expect that similar issues will continue to exert impact on the business going forward.
Mitigating future risks
To illustrate how to mitigate future risks, here’s an example from the environmental pillar of our ESG approach: An integrated oil company has material and probable future cash outflows consisting of asset retirement obligations that are related to retail gas stations and refineries which are expected to be realized in 1–50 years. We would introduce a liability into our analysis for the decommissioning costs of these oil installations to the extent that the company is obliged to rectify damage already caused.
Furthermore, the company’s refineries may come under the European Union’s greenhouse gas emission trading system and be granted a certain amount of emission allowances for a specified time period. We would include an environmental liability to cover the obligation to buy emission allowances if emission allowances received free of charge and purchased emission allowances intended to cover the deficit do not cover actual emissions and data is available to determine this liability.
Value-based exclusions and engagement
Exclusion and engagement are an important part of Evli’s ESG process.
Some values-based exclusions are integrated into portfolio management. Controversial weapons manufacturers, tobacco manufacturers, adult entertainment producers, controversial lending, thermal coal mining and generation (30% revenue threshold), oil sands extraction (30% revenue threshold) and energy peat producers are excluded from Evli’s investment universe.
We have a conduct-based engagement policy and monitor our investments based on the United Nations Global Compact framework. In case of a severe conduct-based violation, Evli will engage with the company and may ultimately exclude it from our investment universe if the response is unsatisfactory.
A word of caution
An important aspect, worth repeating over and over, is our risk conscious and value-oriented attitude.
We do not want to pay for future growth scenarios or positive opportunities, be they due to traditional financial variables or ESG, because of the risk of overpaying for the stock. Skepticism is hardwired into our strategy and we won’t get sucked into hype whether it is about bitcoins, gold bars or ESG ratings.
Any responsible, sustainable and financially successful company can be a bad investment at one share price and a good investment at another share price. Valuation discipline requires us to sell an expensive stock no matter how “green” or “good” it is. If every “green” security in the market is overpriced, we may take the opposite bet and choose a contrarian “anti-green” portfolio. Same applies for ESG-ratings in general: if firms with high external ESG-ratings are overpriced and firms with low external ESG-ratings are underpriced in the market, we could favor ‘low ESG-rating firms’ (as long as they pass our internal ESG analysis).
Price is what you pay, value is what you get, and value equals expected discounted free cash flow.
