The sheer amount of information and conflicting signals can be confusing to an investor. How, for example, do you assess the ESG performance of companies in emerging markets, where our Evli GEM fund invests?
If you're not careful, the overflow of information can put you in a state of desperation when looking for investments. Company financial statements can be viewed from many different angles and compared using a variety of ratios and multiples. Company management publish their plans for the future and analysts evaluate them. You’ve got data that covers the whole economy or a specific industry, not to mention ESG data related to the environment, society, and good governance. Based on this information, it is often possible to make a strong case both for and against an investment. So, how does one bring clarity, calm and consistency to the decision-making process?
Let’s take ESG issues in emerging markets equities. Would it be possible to tackle the wave of information with, say, a single indicator, like an ESG score, produced by a third party? Typically, the purpose of a score is to describe the material ESG risks and opportunities facing a company and its industry, how exposed it is to them and how well it manages them - including relative to its competitors.
The ‘easy solution’ illusion
For the investor, however, the ESG rating does not necessarily tell the whole story of a single company. Based on the model of those who make the ratings, a company may do well in its own industry in matters of responsibility, but for the investor, the industry itself may be a problem. It may also be that a particular conflict, risk, or opportunity is weighted in the ratings model in a way that does not fit the investor's approach.
Sometimes a company can move from one sector classification to another in the rating provider’s books when the focus of the business changes enough over the years. As a result, not only does the peer group change, but the ratings model used to assess the company's ESG risks and opportunities in the new industry is likely to change as well. A good ESG rating may drop to poor or rise from poor to good, even if there has been no dramatic change in the company's operations. This happened recently to a company whose main sources of revenue had long been the making and selling of vehicles. It had received a fairly good ESG rating under that industry classification, but after the change to a conglomerate, the rating dropped by two notches.
Even before the change in the sector classification, the company's story was not clear-cut. Its best area for a decent ESG score was the environment, but the future outlook was compromised by the low share of electric and hybrid vehicles in the product portfolio. One of the company's other divisions is in coal mining, which is problematic in terms of climate change mitigation and remains a major source of energy in the company's home country. The impact of its palm oil plantations on the environment might also require investor scrutiny. There are many issues that could be addressed in a sustainability analysis and an ESG rating is only one view of the situation.
However, the most obvious problem with the use of ESG ratings in emerging markets is the lack of data coverage, as some companies, especially among the small and medium-sized ones, are not covered by the ratings. Should we not invest in these companies at all, or just try to make sense of that web of data anyway?
Choosing principles in advance
The risk is that without a clear plan, an investor can be distracted by irrelevant information and mixed signals. If our approach to investing were to be described in one word, it would be focus. We have carefully considered and selected what we believe are the essential selection criteria, including our ESG principles. The selection of investments and the construction of the portfolio should be as clear and smooth as possible, without the portfolio manager's personal preferences, biases or prejudices determining the content of the portfolio. No matter how much financial statement or ESG data is available, we focus on information that our investment process defines as essential.