Companies that work responsibly and with a long-term approach in environmental and social matters generate greater return on invested capital, according to an analysis by Nordea Funds. According to Sasja Beslik and Mathias Leijon of Nordea Asset Management, this requires owners to be actively engaged and to have a long investment horizon.
It is argued all too often that taking responsibility for environmental, social and governance matters involves an additional cost for companies, and that it would hence be disadvantageous, in purely financial terms, for asset managers to take such matters into consideration in their investment processes. In our view, this is extremely short-sighted and leads to unwise investment decisions. Nordea’s analysis shows that, by working with sustainability, companies extend their lasting competitive advantages and reduce cash flow risks. On the whole, this has a positive impact on the long-term value of their shares. So, it is for financial reasons that companies should focus on creating appropriate environmental, social and governance (ESG) processes. On the whole, our analysis shows that ESG-proficient companies have a return on invested capital that is around 1.5 percentage points higher, and have returned far in excess of the stock market over both 5 and 10 years.
In our view, it is crucial to have a long-term investment philosophy and concentrated portfolios with a high active share (deviation from index), and to engage in the companies’ long-term strategic capital and resource allocation in order to be able to generate long-term value added for fund investors. It is the companies’ ability to generate cash flow at a low risk, and allocate cash flow rationally, which drives shareholder value over time.
In order to succeed in the ambition of putting ESG higher up on corporate agendas, the financial industry must be better at drawing attention to the positive financial consequences of proactive work in this area. We believe that positive incentives, such as increased long-term shareholder value, are a stronger driver in compelling various groups of owners than the basic requirements for a company to act appropriately and decently. However, an in-depth analysis is required as a basis for this dialogue.
We have chosen to actively engage in companies irrespective of how ESG-proficient they are currently, provided that they have a tangible willingness to change. As a responsible owner, in our view only investing in companies that top the ESG league is not the right approach, either for shareholders or society at large. For shareholders, this might mean missing out on investing in potentially good companies with declining risk. By influencing companies into taking the right measures in the long term, the value of the investment increases, and this is what active ownership is fundamentally all about.
A market with an increasingly short-sighted focus on quarterly reports poses a major challenge to companies’ long-term investment plans. We see a trend towards increasingly passive ownership on the stock market. The problem is that passive owners do not necessarily take responsibility for creating stable, well-invested companies over time. A computer can’t provide opinions and perform in-depth analyses. Companies thus risk missing out both on a sounding board and a requirements specifier in the form of long-term responsible owners.
In the short term, companies that under-invest in ESG might save money. Yet, when reality catches up with them, money and resources will be required from the business to deal with the crisis, potentially paralysing the company for a lengthy period.
We urge companies to have the nerve to disregard the increased short-sightedness of the market and concentrate instead – through a heightened ESG focus – on bolstering their lasting competitive advantages and reducing risk and volatility in generated cash flow. This requires investments that will not generate return until in the long term. This naturally requires managers, fund investors and companies to have a shared view of what is meant by “long term” and, in our view, investors in shares and funds ought to consider a horizon of up to 7 years for their investment.
Going forward, Nordea will sharpen its requirements for individuals with ESG experience to be on the boards of our Nordic holdings. We do so because we are convinced that improved processes in this area generate better risk-adjusted return for our unitholders. We believe that a more balanced board in terms of background, gender and ethnicity helps achieve better capital allocation decisions on the whole, which will generate greater shareholder value in the long term. The fact that this will lead to a more sustainable society over time is of course highly positive too.