Equity Investing with an Ownership Stake - Summary

Equity Investing with an Ownership Stake

Key Concepts

  • Equity investors are residual claimholders, bearing the most risk and reaping the most benefits from a company's success or failure.
  • Most equity investors don't adequately consider material sustainability issues, lacking frameworks and incentives for integration.
  • Sustainability needs to be incorporated in mainstream finance.

Sustainable Finance (SF) Typology

  • SF 1.0 (Exclusion): Excluding companies/projects with negative social/environmental impact.
  • SF 2.0 (ESG Integration): Incorporating ESG factors and risks into decision-making.
  • SF 3.0 (Impact Investing): Analyzing social/environmental impact before considering financial returns.

ESG Approaches in Equity Investing

  • Exclusionary ESG Screening (SF 1.0):
    • Goal: Maximize financial return subject to minimum social-environmental value.
    • Focus: Operations.
    • Investment Universe: Very large, excluding the worst.
  • ESG Integration (SF 2.0):
    • Goal: Maximize integrated value (financial + social-environmental).
    • Focus: Operations and products.
    • Investment Universe: Excludes the worst 20-30% based on S and E.
  • Impact Equity Investing (SF 3.0):
    • Goal: Maximize social-environmental value subject to minimum financial return.
    • Focus: Products first, then operations.
    • Investment Universe: Only the best 10-30% in terms of S and E.

Learning Objectives

  • Describe the state of ESG integration into equities.
  • Explain the link between ESG integrated analysis and understanding of companies.
  • Describe the difference between ESG investing and impact investing.

Types of Equity & Investing

  • Equities:
    • Private
    • Public
  • Equity Investing:
    • Passive (index choice)
    • Active/Fundamental (business fundamentals choice)

Active vs. Passive Investing

  • Passive Investing:
    • Investments in indices or ETFs.
    • Cost-effective.
    • Limited societal allocation role (SF 1.0).
  • Active/Fundamental Investing:
    • Analysis of financial statements, business models.
    • Identifies material ESG issues.
    • Best able to undertake ESG integration (SF 2.0).

Equity Valuation Methods

  • Relative Valuation:
    • Compares a company to its peers.
  • Absolute Valuation:
    • Uses Discounted Cash Flow (DCF) model.
    • 0=FCF<em>1(1+WACC)1+FCF</em>2(1+WACC)2+…+FCFn(1+WACC)n0 = \frac{FCF<em>1}{(1+WACC)^1} + \frac{FCF</em>2}{(1+WACC)^2} + … + \frac{FCF_n}{(1+WACC)^n}
    • Where FCF is free cash flow and WACC is the weighted average cost of capital.

Fundamental Analysis

  • Knowing the Business
  • Analyzing Information
  • Forecasting Payoffs
  • Convert Forecasts to a Valuation
  • Trading on the Valuation

Value Drivers

  • Sales (volumes and price).
  • Margins (costs analysis).
  • Capital (cost of capital, capital expenditures, working capital).
  • Sustainability issues can affect value drivers.

Relevance of Sustainability to Equity

  • Business models link ESG and finance.
  • Financial analysts need to investigate the business model to understand long-term value drivers.

ESG Integration: Why?

  • Lowering risk.
  • Increasing return (alpha).
  • More firms aim to lower risk than enhance returns.

ESG Integration: Why Not?

  • Difficulty in expressing sustainability effects in monetary terms.
  • Limited, unverified, non-standardized ESG disclosures.
  • Long-term impact of ESG issues vs. short-term investment horizons.

ESG Integration: How?

  • Exclusionary/Negative Screening
  • Best in Class
  • Active Ownership
  • Thematic Investing
  • Impact Investing
  • ESG Integration

Suitability of Approaches

Fundamental equities is by far the most suitable to all six approaches, since it allows for a thorough analysis of a company’s business model and transition preparedness. Passive investing is least suitable, as it relies on indices. ESG-adjusted indices, which rely on external ESG ratings, have their own limitations.

Value Driver Adjustment (VDA) Approach

  1. Identify & focus on the most material issues
  2. Analyse the impact of these material issues on the individual company
  3. Quantify competitive (dis)advantages to adjust for value driver assumptions
  4. Have an active dialogue

ESG Integration into Passive Equities

  • Exclusionary screening.
  • ESG indices.
  • Proxy voting.

Impact Investing

  • Aims for both financial and societal value creation.
  • Fits with SF 3.0.
    • Intentionality: to make the world better
    • Return expectations: (i.e. not charity)
      GIIN impact criteria

Impact Management Dimensions

The Impact Management Project distinguishes five dimensions that help in assessing impact of a company or project:

Impact criterion

  • Material: relevance to value drivers sales, profits, capex, and risk
  • Intentional: deliberate choice, strategy, purpose
  • Transformational: does the company drive major change for the better by means of its business model, technology, scale or standards?