Quality and Values-Based Investment Analysis: More Similarities than Differences?
Category: Investment Research
Over the past decade, environmental, social, and governance (ESG) analysis has become more broadly accepted as a useful part of assessing the quality, sustainability, and competitiveness of a given business model. While many investors continue to associate ESG with incorporating social values into investment decisions, at its core, ESG analysis provides additional perspective for uncovering positive and negative externalities that may not be apparent from traditional financial analysis. Such externalities can alternatively be classified as business risks or opportunities and carry potential to destroy or create shareholder value. While quantifying the financial impact (and influence on expected return) remains the more challenging part of ESG analysis, investors are becoming increasingly receptive to the idea that the approach has broader relevance than just to values-focused mandates and can be a critical factor in mitigating risk and driving value.
The use of ESG to augment traditional fundamental analysis was highlighted during a recent trip to London where Athena met with the RBC International Opportunities team and also attended the Generation Investment Management annual conference. During time with both of these firms, Athena was particularly struck by similarities between the ESG framework and analysis performed by traditional quality managers. While the terminology used by ESG and quality investors differs, they all share the common objective of finding companies that can sustain and grow their competitive positions.
As an example of how an ESG lens can reveal hidden business risks, RBC highlighted a global beverage company that derives the majority of its revenue from selling a highly caffeinated, sugary drink to a predominately teenage customer base. Although the company possesses attributes associated with a quality investment (dominant market share, high free cash flow, etc.), its competitive sustainability could be compromised by increased regulation. RBC classifies this negative externality as a “contingent liability,” and cites the rise in “sugar taxes” and the clampdown on “candy flavored” tobacco products as examples of how this risk could lead to adverse financial consequences. While a traditional financial analysis framework would most likely classify this business as an attractive investment opportunity, the RBC team chose not to initiate an investment after considering these threats to the company’s financial sustainability.
As an example of how an ESG lens can reveal hidden business opportunities, Generation reviewed the sustainable growth model of a global pharmaceutical company with a “patient first” emphasis (a current portfolio holding). Negative sentiment toward the pharmaceutical industry is often linked to the common practice of increasing the price of medication for rare diseases that typically affect small populations and can be life-threatening. Despite negative headlines and related regulatory initiatives that pressure the industry, this company has decoupled from peers and focused on driving revenue via volume increases. Since a business model based on aggressive price increases conflicts with its “patient first” mission, the company has emphasized treatments for the untreated and inadequately treated, as the potential volume growth presents a tremendous opportunity. The company applied this approach to the treatment of hemophilia and has already achieved an attractive market share. Given approximately 75 percent of global hemophilia cases fall into the untreated or inadequately treated category, this business segment also presents a long runway of continued growth. In summary, while the company’s “patient first” priorities have allowed it to establish a sustainable and growing competitive position, the use of an ESG framework allowed Generation to identify this opportunity in an industry where most participants are pursuing more challenged business models.
As illustrated by these examples, consulting ESG factors provides insight into how traditionally overlooked externalities can influence the quality, sustainability, and competitiveness of a given business model. While quantifying the financial impact remains the more challenging aspect of this type of analysis, asset managers are increasingly receptive to ESG considerations given the risks and opportunities associated with them. Athena Capital is further exploring the commonalities between “quality” and “values-based” investing in order to continue to develop a universe of attractive managers for clients seeking market-rate returns.
 Lester Wan, Elaine Watson, and Rachel Arthur, “Sugar taxes: The global picture in 2017,” BeverageDaily.com, December 20, 2017, https://www.beveragedaily.com/Article/2017/12/20/Sugar-taxes-The-global-picture-in-2017
 Food and Drug Administration, “Regulations of Flavors in Tobacco Products,” Federal Register, March 21, 2018, https://www.federalregister.gov/documents/2018/03/21/2018-05655/regulation-of-flavors-in-tobacco-products.