There are many ways to apply responsible investing principles to portfolios. But some investing approaches may be more conducive to creating a portfolio with strong environmental, social and governance (ESG) qualities than others. Concentrated equities are a case in point.
More investors around the world today are focused on ESG in their portfolios. For some, that means screening out sectors and companies that don’t align with their values, such as weapons manufacturers, tobacco companies or coal-based utilities that pollute the atmosphere. Thematic portfolios that invest in specific sectors with an ESG angle are another way to invest responsibly. Others may want to ensure that ESG issues are incorporated into research before holdings are purchased.
Concentrated Investing: A Natural Sieve
Before choosing a responsible investing approach, investors often ask: will an ESG focus undermine returns? Instead we prefer to turn the question on its head and to ask whether there is a high-return investing approach that can help foster a portfolio with strong ESG characteristics.
Concentrated investors target a small number of high-conviction positions. Choosing a small group of candidates from a vast universe of opportunities requires a well-defined process. In our view, a disciplined concentrated investing process focused on high-growth companies is like a sieve that sifts out companies with weak ESG profiles by following these four guidelines:
Avoid cyclical businesses—Cyclical businesses depend on the economic cycle to outperform and are not well suited to a concentrated growth portfolio, in our view. These typically include companies in heavy industries such as oil and gas. By avoiding cyclical companies, a concentrated growth portfolio will filter out heavy polluters, almost by default. Noncyclical companies include healthcare, life sciences and technology groups, which often perform well on environmental and social issues. Excluding cyclical businesses leads to portfolios with a substantially lower carbon footprint than the broader index.
Engage often with management—Engagement is important for any active investor. But concentrated investors can take a highly proactive approach because there are far fewer companies in the portfolio to engage with. Keeping in close contact with company managements is an essential ingredient for effectively promoting positive ESG changes in a company.
Beware of regulatory risk—Concentrated investors should stay away from businesses that are subject to significant regulatory risk, in our view. Regulatory action is almost impossible to predict and the risk of a share price imploding over a regulatory issue is too great to bear in a portfolio with so few stocks. By steering clear of heavily regulated industries, a concentrated portfolio will usually rule out problematic holdings such as tobacco, energy and utility companies.
Concentrate on highly profitable companies—This is a primary focus for a concentrated growth portfolio that also produces a positive ESG tilt. What does profitability have to do with strong ESG practices? In our view, companies with high margins are more likely to have the resources to invest in environmentally and socially responsible initiatives than companies with tighter margins. Companies that are squeezed on profits have in-house financial issues to address before allocating funds to make the world cleaner.
The Growth Dimension
Targeting growth companies adds another dimension to a concentrated investing approach—and has implications for ESG issues. In many cases, growth companies are found in newer industries. That means they have fewer legacy issues to address when planning for the future.
For example, a company that has traditionally relied on coal may have a tough time weaning itself off a dirty energy source that is so much cheaper, especially if the switch would reduce profitability. Older companies will also typically have sunk significant costs in existing processes, making it harder to change direction. And governance standards have changed so much that a newer company may have an advantage over an older peer, which may be steeped in corporate traditions and practices from another era. Simply put, companies in newer growth industries are less likely to run into historical problems getting in the way of planning the future and implementing good ESG practices.
Fundamental Fieldwork Is Essential
Finding companies with a solid ESG pedigree requires a lot of fieldwork. While agencies like MSCI provide a good framework for an ESG discussion, we believe that data and ratings don’t tell the full story. To fully assess ESG issues that companies are facing, investors need to really understand how their businesses operate. ESG standards are rapidly evolving, which requires analysts to understand how future changes could affect the business environment. It also takes a broad perspective across regions and sectors to fully grasp how a company stacks up against its global peers on ESG criteria.
Here, too, concentrated investors may have an advantage, in our view. Investing in a relatively small number of stocks allows a concentrated portfolio manager to spend more time digging into the details of each company’s business. Unlike rating agencies, which may take time to update a view of a company as events unfold, portfolio managers who own just a few stocks can move much faster and engage with management to evaluate changes in real time.
Engagement efforts are more effective when investors have a long-term position in a company. Buy-and-hold investors can have greater influence on a company when management knows that a shareholder is in it for the long run. This also allows an investor to monitor and report on a company’s ESG behavior over time, while incorporating changes and improvements in fundamental analysis.
In a world of ever-increasing options, it can be confusing to find the right balance of returns and responsible practices. There are many solutions for investors to choose from that focus on ESG issues. But some investing approaches may actually help investors reach responsible investment objectives by virtue of the way they search for returns.
Mark Phelps is Chief Investment Officer—Concentrated Global Growth at AllianceBernstein (AB)
James T. Tierney, Jr. is Chief Investment Officer—Concentrated US Growth at AllianceBernstein
Ton Wijsman is Senior Investment Strategist—Equities at AllianceBernstein
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.