ESG refers to a set of factors (Environmental, Social and Governance) that affect the ability of companies to generate sustainable returns over the long term. 

Investing through the ESG lens involves understanding the governance structures and culture of a company, employing a broad view of changes taking place in the world and assessing the effect these can have on a company’s cash flows, balance sheet, reputation and, ultimately, corporate value.

As stewards of our clients’ capital, we take a holistic view of our investee companies, looking at all material information, whether quantitative or qualitative. There is compelling evidence that ESG factors influence returns over the long term, and therefore must be incorporated by fiduciaries when assessing risks and opportunities. 

As active investors, we take the position that true stewardship entails going beyond passively investing and requires us to take an active approach to steering our investee companies towards creating superior ESG outcomes. 

The recent COVID-19 crisis and fall in dividend payouts is an example of how an active approach to ESG through true stewardship can create tangible differences to our clients’ investment returns. 

Our process

As bottom-up investors, our process starts at the company level. Once an investment prospect has been identified, we subject it to rigorous fundamental analysis and peer review to decide whether it merits inclusion in our high-conviction portfolios.

ESG analysis is embedded in this assessment, influencing key assumptions such as the cost of capital, revenues, or costs - and thus our estimate of a company’s intrinsic (fair) value.

In broad terms, we divide our process into three categories: identification, integration and active ownership. Responsibility for this work lies with the portfolio managers and analysts – the people who know the companies best. In this way, we can achieve true ESG integration.   

Active ownership, governance and dividends

The G in ESG stands for governance. In our income portfolios, we place a particular emphasis on governance, which stems from the belief that this is a fundamental determinant of long-term performance. 

Governance issues are often reflected in a company’s environmental and social record, making it a reliable proxy for wider sustainability. 

For mature businesses, dividends are an important source of shareholder returns. And while boards and company management usually do the right thing, there are cases when companies retain capital that could and should have been paid to shareholders.

Sometimes this is done so that managers can expand the scope of their corporate domain. At other times, it is retained under the auspices of conservatism by management, who feel they require extraordinary financial cushioning upon which to run the business. 

We view a company’s commitment to regular dividends as an important source of capital discipline and therefore a critical element of a company’s governance profile. For us, these dividends represent a commitment to shareholder return. 

In the same way individuals demonstrate a commitment to funding their retirement by saving a portion of their wages each year, a mature company demonstrates its commitment to shareholder return by paying a regular stream of meaningful dividends. 

Thus, when an investee company with a history of dividend payments cuts or significantly reduces its dividend, we do not take it at face value that this is the correct decision. 

As stewards of our clients’ capital, we have a duty to probe the reasoning behind dividend cuts and, ultimately, to resort to activism if we find the decision is not merited by the underlying business case. 

The recent COVID-19 pandemic provides a particularly compelling example of the value generated by our active approach. 

COVID-19, dividend outlook and activism

The economic lockdown in response to the COVID-19 pandemic has created a uniquely challenging environment for many traditionally robust businesses. This difficulty is being reflected in the near-term outlook for dividend payments for the wider share market. 

For example, as of 31 August, based on broker consensus estimates for next 12 Months dividends, the dollar dividend stream for the Martin Currie Equity Income strategy has been revised down by approximately ~25% since the start of February (pre-COVID-19) estimates . 

For the broader market (i.e. S&P/ASX 200), it is down almost ~40%. But while it must be acknowledged that many companies are reckoning with real existential and solvency issues related to these economic conditions, not all of them are facing the dire outlook the financial media might have you believe.

As such, we were concerned to hear that many of the high-quality ASX-listed companies we invest in for our clients were equivocating about whether to pay dividends. 

Given the important role dividends play during times of crisis, and the robust cashflow profiles of many of these high-quality companies, we felt it necessary to take an activist approach to the dividend question and sent the following (abbreviated) letter to all the investee companies in our income-oriented strategies:

Market response

What was the outcome of our activism? I am pleased to report we've received remarkably positive responses from our investee companies. In many cases, the Chair of the company has taken the time to write a detailed reply rather than just an acknowledgement. 

One Chair of a large company said he had been writing about the importance of dividends since the 1990s. He noted that companies receive up to 20% of their dividends back in reinvestment plans, and if they're worried about cashflow, dividend reinvestment can be underwritten for a small fee. 

Another company, a utility, attached our letter to the board papers. They've just announced that because they have a high free cashflow, they will pay special dividends next year. They were pleased with the letter and said it was timely.

Contrary to what you might expect, this positive response to our active ownership approach is actually the norm. When it comes to ESG and specifically governance, companies most often want to do the right thing for their shareholders and stakeholders, but may hesitate when given little or no clear guidance from their board or the broader market. 

Like a good coach or mentor, we find our active approach to ownership provides management with the confidence to act with conviction through the knowledge that they are governing in alignment with their most important stakeholders.  

[1] Source: Martin Currie as of 31/08/2020, Next 12 Months (NTM) Income yield is calculated using the weighted average of broker consensus forecasts of each portfolio holding –because of this, the returns quoted are estimated figures and are therefore not guaranteed. Assumes zero percent tax rate and full franking benefits realised in tax return for Martin Currie Equity Income.