Generally speaking, we are used to things getting better. Obviously the current pandemic is a (hopefully) temporary break in that trend, but it does not alter the fact. Life expectancy, infant mortality, quality of life, access to communication and other services are all on a generally improving line. From a global perspective, in most measurable ways there has never been a better time to be alive. This is true for us humans, but almost completely untrue for every other species on the planet.  Our trend of rising prosperity brings increased consumerism, which demands the production of ever greater quantities of goods. Not only do we want more but there are more of us to want it and as our population grows the sad corollary is that the population of every other living thing declines. As China’s failed one child policy has shown us there is no absolutist solution to population control so we must deal with this trend as effectively as we can by using innovation, improving education and applying common sense strategies in our own lives while encouraging others to do the same. Reuse, recycle, mend and maintain; think twice before buying that item wrapped in plastic; invest in ESG.

Invest in ESG – but what does that really mean? In a recent discussion with a young lady just beginning her working career we got onto the topic of ESG investing. Like most people of her generation she was (rightly) strongly supportive of the concept and made sure that her investments went into suitably labelled funds. However, beyond a broad wish to make a positive contribution with her money she was understandably vague about the sorts of companies that she would ultimately like to be invested in.

Somewhat mischievously I asked her ‘ how about an industrial heat treatment business?’ and she winced. This would be a common response I suspect yet highlights one of my concerns about the shallow thinking behind much of the investment into ESG in general.

The industrial heat treatment business in question is Bodycote Plc. This is an example of a high-quality UK based engineering company, founded between the wars in Leicestershire but which only entered the heat treatment business in the late 1970s. The company has a strong tradition of innovation and has grown organically and through acquisition to be a leading player in the industry. Unsurprisingly heat treatment is not something many people think about but is an essential process in many mechanised industries. The process dramatically improves hardness and thus durability. It significantly extends the life of mechanical components as well as allowing them to be smaller and lighter. Gears, bearings, cutting tools, fasteners and many other applications rely on this process. Without it, engines and turbines would be less efficient and require more maintenance, drive shafts and components would be heavier requiring more energy – more petrol or wiggly-amps in your car. So while the process of heat treatment is itself energy consumptive, it more than makes up for this in the energy it saves over the lifetimes of the components it creates. Wind turbines, for example, would not be viable without the process of heat treatment.

Bodycote is an example of a company whose operations are not obviously helping to reduce our environmental impact yet are clearly contributing behind the scenes. It is the contribution made by these somewhat hidden, second tier businesses which needs to be better understood by environmentally conscious investors. Like many industrial companies Bodycote has made mistakes which have led to brushes with environmental agencies and there is clearly room for improvement in their practices. But companies are ultimately beholden to their shareholders and active investors have a key role here to engage with the management and push them in a positive direction. “Responsible’ funds which avoid companies in essential industries like this and starve them of capital will not help in the joined-up process of reducing global emissions. There are many examples of industrial companies who devote enormous sums into research and development to drive efficiency gains such as better conductors for electricity distribution, improved lubricants to extend product lives and reduce energy loss, and new compound materials reducing weight without compromising strength. They play a vital role in helping to achieve the global CO2 emissions targets but get little public recognition.

Bodycote is a longer term holding for the Columbus Fund and is a great example of a well managed champion in its niche with considerable longer-term growth potential. They have consistently improved their internal carbon efficiency and water usage and are getting better at providing information across a number of  environmental indicators. On top of this the stock offers an attractive and growing dividend sourced from consistent cash flow generation with a conservatively managed balance sheet and a mid-teens return on investment.

Investing wisely for a better environmental future is essential – but let’s remember to look beyond the headlines.

Graeme Bencke


Photo – Bodycote Annual Report

The rapid falls in equity markets earlier in the year spurred numerous reports about the outperformance of ESG funds through this weaker period. To me this reflected the durability and attraction of well governed businesses, as well as the continuing share of responsible investment within overall capital flows. Undoubtedly the data was helped by the disastrous performance of the traditional Energy complex as the oil price fell, a segment avoided by funds with even the faintest tinge of green. Yet even excluding this impact the trend of outperformance by companies with a strong, responsible culture should not have been a surprise.

A recent report from Grant Thornton showed the very strong positive correlation between performance and good governance. The research covered the constituents of the FTSE 350 ex-investment trusts over a 10 year period, and the results are compelling. One of the most notable elements was the exceedingly high correlation between a strong corporate governance score and cash flow generation. Again, to my thinking this was unsurprising, and explains why most long term investors take so much notice of the character and behaviour of management teams. The correlation is high because the former is an important driver of the latter. Management teams not only set the procedural policies of a firm but also set the tenor of the organisation. Culture truly does begin at the top and permeates throughout the business.

While all of this is, I believe, widely accepted it does nevertheless clash slightly with another observation. As an investor I have long been drawn to companies with significant family ownership. My experiences here have generally been very positive with my longer term approach typically aligning well with that of the majority owner. Many of these companies score highly in terms of strategy, internal investment in both plant and people, as well as flexibility and creativity. However, it is not uncommon to find less than best practice in some areas of corporate governance. For example, in my experience it is not uncommon to find a weaker than average showing in important elements such as the ratio of women on boards, and the true independence and influence of non-execs. In addition, family led companies may also be less inclined to consider wider societal issues if they impact their own bottom line. The academic literature is somewhat mixed here but in 2015  Rees & Rodionova concluded that “when it comes to investments that foster social good but do not guarantee financial returns, families tend to act as financial wealth maximizers and tend to hinder such expenditures.”

If this is right, how do we square this particular circle? If strong and demonstrable corporate governance is a key factor in longer term performance and family run businesses do not necessarily excel here, why do they still outperform? I think the answer is simply that they have the best interests of the company at heart. In order for a business to go on delivering over many years it needs investment and guidance. Family owners know this all too well, but they care less about proving it to the outside world. The capital market’s focus on good governance is to prevent poor behaviour which is ultimately costly for shareholders. A career CEO joining a new business could be more concerned about feathering his or her own nest for the next few years than steering the company into the next decade. External scrutiny is therefore a powerful force to limit this behaviour. Non-execs have a crucial role to play here by holding management’s focus across all stakeholders and steering an alignment of interests.

What to do? Ultimately if a family remains in control of a firm it is very difficult for minority shareholders to force change in these areas, but they can apply pressure. Obviously as more and more equity capital resides in the hands of ESG savvy investors the companies which score poorly in these areas will likely face declining investor interest and their share prices will suffer. This passive trend is certainly helpful but is also slow moving. This is where dialogue is so important. Even minority shareholders can bring about change if their views are clear and backed by evidence. Sometimes the best performing family companies sometimes need a nudge in the right direction. Bringing together the benefits of robust governance with the typical family focus on longevity of future cash flows is a powerful combination for the longer term investor.

It is clear from the numerous surveys carried out around the world that the importance of ESG to professional investors and individuals continues to grow each year. This sentiment comes from a good place, and aims to right the inequalities and inefficiencies inherent in our society today. Frequent headlines about climate change, poor working practices and the gender pay gap serve to reinforce these views in the minds of consumers, and harden their resolve to act. This rising ground-swell of popular opinion has been progressively pushing a somewhat reluctant financial services industry further down the ESG path every year for at least the last decade. What started as a fringe activity has now become very much mainstream. In the UK in particular wealth advisors and investment managers already see a clear ESG commitment as being a minimum entry point for attracting new assets. Yet despite the demand and the huge resources now focused on addressing it, there remains no clear rule book to follow.

Vast marketing dollars are spent demonstrating individual firm’s commitments to ESG and yet it remains remarkably difficult to accurately compare one fund from another without recourse to simple exclusion lists (no defence or tobacco etc) or even simpler returns performance. Other comparisons are rarely truly like for like. Cynics would argue that this is simply the industry using obfuscation to its advantage while making very few real changes to the way investment is done – and a few years ago I would have agreed. However, this view now seems outdated as there are genuine indications of change across many firms, not least from the rising internal importance of sustainability roles. Senior management have got the memo and they are driving real change. The intention is clearly there, but the picture remains just as confused.

Having been several times involved in incorporating ESG standards into fundamental equity investment processes I am acutely aware of the vast landscape of options that need to be considered. Much of the problem stems from the name. ESG is a catchall term that encompasses so many elements from board composition and gender pay, to biodiversity and carbon emissions. This is matched by a bewildering array of organisations offering different standards, goals and frameworks for reporting and analysing behaviour right across the spectrum. As a result It is easy to become overwhelmed by the complexity and end up achieving very little of tangible benefit. I believe this is a significant contributor to the accusations of ‘green washing’ across the financial services industry. In an effort to avoid this label investors have increasingly moved towards a box ticking approach to at least show something tangible to clients and prospects. After all, in order to achieve real change we must have real targets. The intention here may be the right one, but it is also the source of my concern. This approach can lead to an overly narrow review of the target company, and may lead to analysts simply going through the motions. Less scrupulous companies can provide shallow responses in order to tick the box and move on. This helps no-one.

Ultimately a positive ESG approach must begin with culture and intent. As investors we have not only a fiduciary duty to clients, but also a wider societal and environmental responsibility. In order to fulfil these roles we must understand the true attitudes and objectives of the companies we research, and they must understand ours. ESG is a dialogue in which management teams must understand that entrenched attitudes and behaviours are no longer acceptable. In order to achieve the environmental and societal aims that are increasingly pressing, change must happen. Each company faces a different set of challenges and can contribute in their own way. Heavy users of energy or raw materials will clearly have a different focus to asset-light service companies, and it is the analyst’s role to ensure that the right targets are being set and achieved. Tools such as the SDG Compass and the SASB materiality maps can help with this process. The key is to engage so that execs know that their feet are held close to the fire, and investors feel the same pressure from clients and the public. In the longer run this should be beneficial for profits and all concerned as change for the good will pay dividends in terms of improved energy efficiency, more transparent supply chains, better customer retention and reduced staff turnover. These tangible improvements can then be related to shareholders and their clients.

ESG is rapidly becoming a standard part of the investment world and no longer the differentiator it once was. Now the industry needs to talk less and achieve more, and the actions will speak louder than the words. Corporate responsibility is the responsibility of all stakeholders, and it begins with asking the question ‘what are you doing today to make tomorrow a better place?’