COP26 will rightly mean even greater scrutiny on how fund managers integrate ESG factors into their investment processes. Already lawmakers are looking closely at those who overstate the sustainability claims of their firms or products, but the greatest pressure will come from asset owners. From the smallest savers to the largest pension funds, clients want to see how their capital is being invested and whether it aligns with their own beliefs.
The good news for stock pickers like SKAGEN is that companies also face rising pressure from their own clients to set climate targets and scrutiny over how, when and whether they're being achieved. Regulators and industry bodies play an important role here too, particularly in standardising disclosure; the Task Force on Climate-Related Financial Disclosures (TCFD) and recently launched International Sustainability Standards Board (ISSB) being notable initiatives.
While multinational frameworks to improve consistency and ultimately behaviour are welcome – particularly for investors like SKAGEN who invest using unconstrained global mandates – their breadth can also slow their effectiveness in tightening the screws on businesses. In providing a renewed sense of purpose, COP26 can hopefully help to accelerate and consolidate many of these macro initiatives currently underway.
Responsibility to clients
Our fiduciary responsibility as active investors is to find companies that will provide the best possible risk-adjusted returns for our unitholders. Climate risk is the major life threating change we face – ignoring this would be a huge breach of our duty to clients.
Instead, it forms an important part of our analysis when making investment decisions and only companies we believe will play their part in solving climate change will be selected for our portfolios. Those that are part of the problem will inevitably suffer in the screws of regulation and fall behind. The risks for the laggards – and their owners – have only increased following COP26. Conversely, for companies that have the engineers, innovation capacity and investments in place to secure their competitiveness, the potential rewards have never been greater.
This gives active managers a clear advantage. We can decide which companies to hold, how much exposure we want and when to sell. Contrast this with passive managers who base investment decisions solely on company size in order to replicate an index. While some exclude ESG laggards from their investment universe many don't, illustrated by a recent Reclaim Finance[1] study which found that only 2.5% of the $13 trillion assets managed by the world's largest passive managers exclude coal investments.
Active owners – particularly those with concentrated portfolios like SKAGEN – also have the upper-hand in monitoring and discussing ESG issues with the management teams they meet regularly, even more so if that relationship has been built over a long holding period. Stock-pickers better understand the impact that ESG issues have on valuation, both negatively when assessed alongside other investment risk factors and positively as a re-rating catalyst.
Winning the race
As ESG becomes an increasingly important driver of sentiment and valuation, it adds an extra dimension to the challenges faced by active managers, particularly those focused on value like SKAGEN. In general, we view companies as either tortoises or hares. Tesla is a typical hare. Despite a decade of losses, the company has enormous upfront support from investors who have bought into its successful vision of creating the first mass-produced electric vehicle.
Meanwhile tortoises such as VW, which is investing €19 billion into electric vehicle production over the next four years and forecasts they will account for the majority of its global sales by 2030, are quietly transforming the EV market. Another is Toyota which expects 70% of its international sales to come from electric models while Volvo has even more ambitiously committed to exclusively sell electric cars by 2030.
The ultimate goal for society is to decarbonise the auto industry, which accounts for 27% of EU greenhouse gas emissions, whereas manufacturers' goal is to win the race and provide shareholders with the best possible risk-adjusted returns. With the tortoises valued at between 8- and 12- times earnings while the hare's P/E is 377x, only the foolhardiest investors would bet against them.
COP 26 also underlined the political challenges we face in tackling climate change. Several world leaders failed to attend and those that did made questionable progress to deliver the tangible plans required to reverse global warming.
This also serves to remind us of the beauty of private enterprise and how fierce free market competition is probably our greatest hope for the future. Rather than sitting on their hands and waiting for regulation to hit them, many companies are proactively adapting and contributing to the enormous transition we are living through – see below for three portfolio examples of tortoises that could easily have remained in their shells but instead chose to invest, innovate and beat the competition.
Our job as investors is to take calculated risk. No companies are without challenges and it is how these are navigated that provides us with valuable insights into the potential for value creation in future. Although the risks for companies that fail to meet them are bigger than ever, the rewards for those that succeed have never been greater.
NB: All figures as at 30/09/2021 unless stated
Footnote:
[1] Slow Burn: The asset managers betting against the planet. The Inaugural 2021 Asset Managers' Coal Scorecard. April 2021