“When it comes to reducing carbon emissions or producing renewable energy, all sorts of innovations are suddenly possible that you couldn’t have imagined even five years ago,” says Silvia Wegmann, Head of Julius Baer’s Investment Management Sustainability Boutique. She cites the example of an insulation panel manufacturer she’s currently screening. “Europe could cut its energy consumption by roughly 35% through better insulation. However, the fossil-fuel-based foam insulation products that dominate the market are not recyclable. We’re currently examining a company that has developed the technologies to retrieve plastic from the ocean and to ensure its materials can be re-used when their life cycle is over.”
Silvia and her team devote much of their time to identifying sustainable companies for clients to invest in. But what, in her view, does sustainable actually mean? “Sustainable investing is built on an understanding that the company’s strategy and targets are informed by factors such as the environment, society, and corporate governance,” Silvia explains. Her team places an additional focus on innovation. “For us, a sustainable leader is a company that has a forward-looking approach. It’s not a company that wants to sit on a cash cow, but an organisation producing goods and services that will be useful for the next generation.”
She explains that the team isn’t just looking for established environmental, social and governance (ESG) champions, but also for companies that are pursuing a sustainable agenda. “The insulation panel manufacturer is currently around 50% sustainable, but it’s showing an upward trend,” she says. “Almost no companies, except perhaps those who are producing wind turbines or solar panels, are 100% environmentally sustainable. The key is to identify companies that are moving in the right direction.”
Five-step approach
To pinpoint companies that are displaying innovation and have future generations in mind, Silvia and her colleagues analyse them along five dimensions:
The team scrutinises each company’s track record forensically, which often involves discussions with representatives from the companies. “I love the interactions with companies and clients,” says Silvia. “Some of them are in the car industry, some in the energy sector, some in healthcare. I’m a very curious person, and when they start telling you about their industry, you discover so many new and interesting topics. It’s the part of the job I love most.”
Does the company have a strong ESG focus?
In a first step, they focus on companies with a strong ESG approach by referring to third-party data and the internal Julius Baer ESG methodology scores. The screening process covers each of the three ESG characteristics in turn. “We look at environmental factors, considering how a company performs as a steward of nature via indicators like greenhouse gas emissions, resource depletion, and biodiversity loss. Then we look at social factors, examining how a company manages its relationships with employees, suppliers, clients, and the community. Next, we examine how the company is governed, looking at topics like bribery and fraud, executive pay, and board diversity.”
After the team has looked at each of these ESG characteristics, it trains its focus on the company itself. Is it exposed to any ESG risks in its industry? Are management practices in place to mitigate these risks? Have any controversial cases been identified and how severe are these? At the end of the screening process, the companies are assigned a score of between 3 and -3 for each dimension. The outcome is an overall assessment of the company into one of the three clusters ‘traditional’, ‘responsible’, or ‘sustainable’.
This first stage is also where certain companies are excluded from the selection. “We don’t invest in any company associated with arms production, or weapons generally,” says Silvia. “We also exclude countries that don’t have a democratic approach or fulfil the Human Rights Convention. For example, we exclude bond investments in companies from countries that still apply the death penalty.”
How is the company’s governance structured and managed?
As a second step, the team performs a governance screen, determining whether the company in question has sustainable goals for its management. With many innovations only coming to fruition several years from today, it’s important for a company to be run by a management team that has long-term goals.
“In the past, assessments of good governance largely focused on topics like corruption, bribery, fraud,” says Silvia. “But that was too narrow. Governance is also about how much of the company’s management chooses to spend on research and development. It’s also a question of how they treat both their shareholders and their stakeholders: their employees, their suppliers, the communities in which they operate, and wider society,” explains Silvia. “If a company was producing high emissions that harm neighbouring communities and its management hadn’t made moves to change this, perhaps for cost reasons, they could hardly be said to be acting sustainably.”
During this governance screen, the team also verifies elements such as accounting and capital expenditures. “Many smaller companies are very innovative, but not a good fit in terms of financials,” says Silvia. “They don’t deliver positive returns or perhaps they only have a single product line or one or two main clients. So, we consider whether companies are well enough diversified. We tend to look at medium to big caps rather than small caps. Smaller ventures might have interesting innovations, but if they’re not earn money on them, they’re too risky for our clients’ money.”
Is a key theme visible?
Following these first two steps, the investment universe has generally been whittled down to around 650 companies. Next, rather than simply making a ‘best-in-class’ selection, the team scrutinises how closely the company fits with Julius Baer’s own thematic focus, which includes three environmental factors (water, low carbon, and resource efficiency) as well as three social factors (nutrition, health, and economic empowerment).
“We take an active rather than a passive approach to sustainability. It’s not a case of sifting through the financials and then hoping to chance upon a company that meets our sustainability requirements. We check the company’s sustainability data along our key themes before we even examine its financial data, rather than vice versa,” says Silvia.
How does the company perform financially?
The fourth step involves a fundamental financial analysis of the company. After all, while sustainable investors embrace companies that operate in a responsible and forward-thinking way, there is still an expectation that their investment offers prospects of consistent returns. “We look at the financial strength of a company whereas our “investment style” is rather “quality to growth,* Silvia explains. “We want to verify that the company has a sound balance sheet, leverage, profitability, and capital allocation, and a healthy cash flow.”
As a final step to ensure ongoing monitoring of the selection, Silvia and her team conduct a weekly exchange within their Sustainability portfolio construction team, during which they gather input from Julius Baer’s Investment Committee, share insights on trends and sustainable themes, and model the portfolios, positioning, and performance.
Increasingly robust reporting
The emphasis that consumers and investors are placing on sustainability has led to concerns about ‘greenwashing’, a tactic whereby companies make vague or exaggerated claims about their sustainability credentials or cover up unsustainable practices with a layer of ‘green’ marketing. However, Silvia believes that greenwashing will gradually fade as it becomes easier to track and compare companies’ sustainability data in black and white.
“Companies suddenly came under pressure when the new ESG regulations and targets were introduced, such as being net zero by 2050, and some of them may have cut corners,” she says. “But the data requirements are becoming clearer and stricter year by year, which leaves less wiggle room. If an oil company claims it’s going to be net zero by 2050, it will have to back that up by showing reduced CO2 emissions in its annual reporting.”
Looking back over the development of sustainable investing over her career, Silvia cites the introduction of the first ESG index by MSCI as a turning point in dispelling myths about sustainable investing. “That meant that we could finally point towards objective evidence that sustainability could support performance. Before that, it was simply assumed that sustainable investments underperformed because these companies spent money for no return just to ‘do good’.”
After 16 years in this field, Silvia says there are no opportunity costs in investing sustainably. “However, you can’t take a short-term investment view,” she says. “It’s all about playing the long game!”