Incorporating ESG into our equity research process

-- | 14/12/2020

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Mark LaMonica: I'm here with Adam Fleck. And we're talking about a hot topic in investing, ESG. So, Adam, we're integrating ESG into our ratings. Why are we doing this?

Adam Fleck: That's right. ESG, environmental, social, and governance, factors we think are essential for long-term investors to consider when you're thinking about a company's future cash flows, its competitive position, and ultimately, the price they should pay for the underlying stock. In many cases, we would have already been looking at ESG factors, either explicitly, say, the utilities analyst looking at renewable energy, for instance, or implicitly as part of our current ratings. But what we're going to be doing is formally and consistently applying ESG factors into what we're doing in equity research.

LaMonica: You mentioned an example. But what are some of the risks that we face from an ESG perspective?

Fleck: I think we can look to Sustainalytics, our partner in this realm. They've identified 20 material ESG issues that companies and industries face, and that ranges across each of those three letters, environmental, social, and governance. So, you can think about some of those might be resource use, for instance, or social impact of a company's products, or human rights. And it really is applied not only at the company level but across the supply chain as well.

LaMonica: Adam, how do the analysts actually estimate the impact of the risks?

Fleck: Well, Sustainalytics through their material ESG issues will form a key input into how our equity research analysts will be estimating the ESG risks. For each of the top MEIs that a company is facing, as identified by Sustainalytics, we will ask analysts to identify ESG risk factors that could eventuate, that could occur, that are tied to those material ESG issues. And as part of that, the analyst will estimate both the probability of that occurrence and the potential materiality—in this case, thinking about the materiality to the company's valuation or its return on capital profile.

LaMonica: How is this actually going to influence the analyst ratings we have, so the fair value rating, the moat rating, and the Uncertainty Rating?

Fleck: Well, for high-probability events, those that we think are more likely than not to happen as estimated by our probabilities, we would expect that to show up directly into the cash flows we're projecting for a company. So, it's going to have a direct impact on the fair value estimate. For economic moat ratings, this again is a measure of a company's sustainable competitive advantages. We want to recognise lower probability but high-impact events that could create a risk of material value destruction. After all, it's no good to any shareholders even if a company has a strong position in the marketplace if there is risk that value could be destroyed in the future. And then, for Uncertainty Ratings, again, we want to look at those low probability, high materiality tail-risk-type events in ESG that could cumulatively lead to an analyst requiring a greater margin of safety before investing, which would lead to a higher Uncertainty Rating.

LaMonica: We've covered a lot of ground here. What are the key takeaways for investors?

Fleck: I think, at the end of the day, it's important to recognise that ESG is essential for thinking about long-term investment. It's a risk that needs to be incorporated into the traditional measures of cash flow, balance sheet, and earnings assessment. We're going to be doing that in a consistent fashion across all 1500-plus companies we cover in a way that we think is clear and integrated for all investors.

LaMonica: Great, Adam, thank you very much.

Fleck: Thank you.

This report appeared on 2021 Morningstar Australasia Pty Limited

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