Article

When it’s better to talk and when it’s time to sell

ESG
Key takeaways
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Investors are often forced to divest when a stock fails their ESG criteria
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This can be avoided through active and positive engagement with management
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Greater engagement can sometimes lead to better outcomes and returns for investors

Selling a stock because it fails to comply with ESG criteria is not the only tool available to portfolio managers when encouraging companies to change for the better.

Ownership of a stock can give portfolio managers a certain amount of say in how a company is run. This is particularly important when investing for environmental, social and governance (ESG) themes or goals.

If a company fails to resolve significant ESG issues, should managers divest and abandon the company?

Oğuzhan Karakaş of Cambridge University’s Judge Business School said the decision to divest was not the only option available to ESG managers. Highlighting renowned economist Albert Hirschmann’s ‘Exit, Voice, and Loyalty’, Karakaş said investors were typically forced into one of two options – exit or voice – when faced with a difficult situation.

While divestment was an ‘exit’ option, engagement was one of ‘voice’, said the academic, and could be considered more of an art than a science.

“Divestment may look like an easy and obvious option, but it may have some unintended consequences,” he explained. “When we look at ‘sin’ stocks – companies that are involved in alcohol, tobacco or gambling – research shows those companies may outperform.

“One of the reasons is that [if] ‘sin’ stocks are shunned or divested by investors, their prices get depressed and hence offer much higher [potential] returns. In addition, once these companies are divested they are bought by investors that care much less about ESG and could therefore be counterproductive.”

Karakaş said successful engagement could also create value for investors.

“There are some sceptics that [believe] dealing with ESG may cause companies to lose value,” he said. He further noted that, while it could be costly, solving ESG issues could also lead to greater efficiencies and help attract longer-term investors.

Erik Esselink, an Invesco portfolio manager and co-manager of one of our European strategies, said engagement was crucial in the investment process and helped improve the sustainability of portfolio companies.

Using in-house data from Invesco’s proprietary tool – Invesco ESGintel – portfolio managers have access to many data points, insights, metrics, an internal rating and ‘direction of change’, and sector ranking from which they can take a view on ESG risks and opportunities.

Esselink said Invesco managers use ESGintel to engage with companies on issues, to aid their understanding of the magnitude and momentum of any problem, and to ascertain how likely the company is to engage with them.

“We set our price targets three years out based on certain earnings assumptions,” he said. “If we, through engagement, can improve the durability or sustainability of this company, the rating at which we can sell the security in three years’ time will be higher. And our shareholders will benefit in this case.”

According to Esselink, this is particularly true of the small-cap space where data quality is poor, which can lead to some companies with considerable valuation uplift being overlooked.

As an active owner, Esselink votes on every stock in the portfolios he oversees. His ability to put pressure on a company may be limited in some circumstances. However, this is where an asset manager like Invesco can use its considerable passive investment business to bring about positive ESG outcomes.

Matthew Tagliani, head of EMEA ETF product and sales strategy at Invesco, said while passive asset managers may have the scale to influence companies, they often don’t have the in-depth ESG knowledge of an active investment firm. 

“We own a large portion of many companies, and we want to wield that strength in a responsible way,” he said. “If there is an active manager in the firm that also owns [a security] we effectively leverage the active portion of the business. It’s called echo voting.”

Despite this internal collaboration, there will still be occasions when divestment is the only option left available to portfolio managers. 

“Most companies know when we ask something we want to have a dialogue,” Esselink said. “‘This is not me telling you what to do. This is me wanting to understand why it is you do what you do and to discuss if there is a better way’.”

However, if both parties are at opposites with little room for engagement, then it could mean divestment, he acknowledged.

Passive funds have little choice in this regard, said Tagliani, but they can decide to change the methodology to ensure that companies not meeting investor requirements are not held in the portfolio.

As such, portfolio managers must think carefully before wielding the divest option and consider whether engagement could yield better outcomes, for both the companies they invest in and their investors.

The above article was drawn from ‘To divest or to engage, that is the question’ session at our ESG@Invesco digital client event on 17 June 2021. Please click here to watch the session.

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