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How ESG Investing is Creating More Resilient Portfolios

2020 taught investors a lot of things, including that sustainable investing helps lower risk during crisis.

As Head of ESG Investment at ClearBridge and a portfolio manager who invests in companies with both fundamental discipline and sustainability leadership, Mary Jane McQuillen is uniquely positioned to offer a close-up view from the firm’s ongoing engagements with CEOs and CFOs of the companies held across ClearBridge portfolios, as well as macro trends and major long-term issues defining the space. 

II recently sat down with MJ, as she is known in ESG circles, to discuss what shaped the broader ESG investing discussion in 2020 and what will have an impact on ClearBridge engagements with companies in the coming months. She highlighted several trends to watch, including the resilience of ESG investing during the COVID-19 pandemic, the growing market interest in ESG integration along the lines of ClearBridge’s model, the utility of global ESG reporting standards and the pandemic’s potential role in increasing the opportunity for companies focusing on sustainable food and packaging. McQuillen also mentioned the burgeoning global investor focus on climate risk and accelerated attention to corporate diversity and inclusion.  

How did the pandemic affect your relationships with your portfolio companies? 

McQuillen: Few were prepared for what 2020 had in store and the overnight change to business operations. Yet stay-at-home orders did not reduce our contact with portfolio companies in 2020 – in fact, we increased our engagements and ClearBridge’s partnership approach to active ownership proved tremendously valuable in the peak of the crisis. As a large shareholder actively engaging with companies often through years of ownership, we have fostered our role as a trusted partner. Our frequent and direct communications with company leaders helped us understand the unique struggles of each company as the crisis unfolded in 2020. We shared our expectations for companies to step up to the challenge for their workers, customers, those in their supply chain, and their communities. As the conversations came to focus also on pressing questions of diversity and inclusion, we continued to have constructive conversations as we worked together to define what is fair, reasonable and beneficial to all stakeholders over the long term. 

Especially in times of crisis, I believe it is important for people to actively partner together: colleague with colleague, company with company, public bodies with private enterprises. We are all expected to find the fine line defining quality near-term performance while maintaining or enhancing the opportunity for superior long-term success. I have been greatly encouraged by the resilience shown by all of us at ClearBridge and our portfolio companies as we looked for ways for all to thrive in a challenging year. 

How did sustainable investment strategies perform in the challenging landscape of 2020?

McQuillen: The NYU Stern Center for Sustainable Business recently completed a meta-study on ESG and financial performance that had a number of interesting findings, most of which are quite consistent with how and why we incorporate ESG into our investment analysis at ClearBridge. The study looks at 1,000 papers published between 2015 and 2020 and serves as a welcome update to previous meta-studies to which we have called attention when asked about the relationship between ESG and performance. 

We are not surprised to see the study show a continuation of the trend that ESG and strong financial performance are positively correlated. The study found that improved financial performance due to ESG becomes more noticeable over longer time horizons. 

Another key finding of the study is that ESG investing appears to provide asymmetric benefits, in particular lower risk, especially during a crisis. Studies included the first quarter of 2020, which saw the worst of the COVID-19-driven selloffs. Some attribute strong performance of ESG portfolios in 2020 to their preference for technology stocks, which broadly did well in a stay-at-home world, and their eschewal of traditional energy, which suffered. 

So, how did ESG stocks do overall in 2020?

McQuillen: Stocks with strong sustainability profiles broadly performed well in 2020, and they did so as a result of a variety of trends. Some of these, such as helping fight climate change by lowering carbon emissions or overcoming resource scarcity through use of recycled materials, we consider to be long-term trends that should support sustainability-focused investments for the long term. The relevance of these themes underscores the importance of being diversified. While 2020 was a strong year for renewable energy innovators and consumer staples names, for example, the sustainability winners over the next market cycle could include discretionary names improving the sustainability of food and packaging, industrials companies enabling electric vehicles and materials companies improving sourcing and creating a more circular materials economy. 

Is there a particular approach to ESG investing that has greater potential than simply screening? 

McQuillen: The Stern study also indicates that ESG integration as an investment strategy performs better than negative screening approaches. While the sample size of studies was small in this case, data supporting the value of ESG integration aligns with our belief that a partnership approach, achieved through an active management model, benefits both shareholders and companies, as well as other stakeholders these groups support. I think companies can make negative or positive impacts on the world, and how we have seen change is by advocating to the people (CEO, CFO, investor relations, managers) at our public companies. When I first began my ESG investing career almost 25 years ago, I was involved in a large variety of company meetings in different industries and could see that investor support for sustainable practices was key for management to hear. Being a large owner of the stock was also helpful in gaining access to leadership with whom we could partner as a long-term shareowner for improvement. These goals have been at the heart of our approach to ESG integration, and it is encouraging to see data confirm them. 

From your perspective, does a global ESG standard make sense? 

McQuillen: Global sustainable reporting standards seem to offer a solution to a perceived problem of subjectivity in ESG criteria. But while ESG criteria apply to different companies differently, this does not necessarily mean they are subjective. It means an investor must have an intimate fundamental knowledge of how a company operates to make objective decisions regarding ESG criteria that are material and relevant. While global standards are excellent guides and help comparisons between companies in different regions, relying on them without a deep understanding of a company’s business model, regulatory regime, products and overall trajectory would be counterproductive from an investment perspective. In addition, the reality is a large population of public companies still don’t report to any established ESG standards, so while a global standard might be more efficient, lack of reporting is the bigger challenge. 

Is there anything happening on the regulatory front that will benefit ESG investors?

McQuillen: Investors in Europe will soon see important changes in the way their asset managers provide sustainability-related information on their products and updated sustainability policies. This is the result of requirements emanating from the European Union’s (EU) Sustainable Finance Disclosure Regulation (SFDR), part of the EU’s action plan for financing sustainable growth. The requirements look to provide transparency and authenticity in sustainability-focused investment products and reduce cases of greenwashing, or those products where sustainability is not truly embedded into processes. This is consistent with our process of explicitly including ESG research in company research performed by all analysts at ClearBridge. As this and past ClearBridge Impact Reports show, this ESG integration is done by all investment professionals at ClearBridge, and thus we applaud the SFDR in encouraging more accountability of the kind ClearBridge has always prioritized and offered. 

Where are you currently seeing opportunity for ESG investors?

McQuillen: While investors seemed to focus on the impact of renewable energy innovators and enablers in 2020, there are certainly other areas of the market to find examples of where innovation is leading to impact and strong performance potential for stocks. We are interested in a diversity of impact, for example, in sustainable food and packaging. Many packaged goods companies have acquired approximately five years’ worth of new consumers since March 2020. While not all will be kept, the industry has woken up to the increased relevance of sustainability credentials for both their consumers as well as their investors, with data showing consumers, especially younger ones, are willing to pay more for sustainable brands. An increased focus on packaging, as well as sustainability across the whole product lifestyle, from regenerative agriculture to recycling/waste reduction, should be a differentiator in the space in the coming years. 

Do you see the pool of investible ESG stocks growing?

McQuillen: We’re often asked whether investments are generally more responsible now than in the past and whether more companies are meeting sustainability targets and becoming desirable for sustainability-focused investors. As I see it, sustainability improvements among companies do increase the pool of companies available for consideration. At some point, most of the market will be composed of companies meeting sustainability targets of one kind or another, and this is also great from a stock picker’s point of view. More companies meeting sustainability targets is encouraging and indicative of more time, effort and capital spent to create a more sustainable and just society. But from the perspective of active owners of stocks, the level of analysis and diligence will remain high. Our investment approach is consistent, focusing on high-conviction ideas and building a concentrated but diversified portfolio, and requires research and selection, rather than just adding more stocks with improving sustainability profiles. Investors, their clients and broad beneficiaries of sustainability practices will still reward the leaders and innovators in sustainability, just as they will leaders and innovators in other areas of operations. 

More companies meeting sustainability targets does, however, raise the bar for all companies, and it also shows the power of those who are leading the way. Companies leading by example and continuously upping their game have competitive advantages. Identifying companies with the foundation laid for constructive stewardship conversations provides us the opportunity to develop relationships or invest in the potential sustainability leaders of tomorrow. 

Learn more about the role ESG can play in your portfolio.

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