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Capital Ideas

Investment insights from Capital Group

Categories
Long-Term Investing
Investment materiality: Applying a more focused ESG lens
Matt Lanstone
Head of ESG Research and Investing

This article, the first in our series on ESG issues, provides some details on our approach and framework to ESG (Environment, Social and Governance) issues. Future articles will focus on aspects of our approach, such as Monitoring and Engagement & Proxy Voting, as well as investment insights on specific sectors, issues and areas of ESG.


As our clients know, Capital Group’s primary focus is to generate sustainable, long-term investment returns for clients that are grounded in fundamental research. ESG has always been a core part of that fundamental research and has been integral to our approach. We evaluate ESG risks and opportunities alongside traditional financial metrics and other business indicators. In 2020, we put a focus on becoming more explicit and systematic about how we integrate ESG. This objective is consistent with our longstanding mission to improve people’s lives through successful investing.


Our integration of ESG is centered on three components: investment frameworks, a monitoring process, and engagement and proxy voting. Internally, we describe this approach as using a lens of “investment materiality.” The scope of ESG issues in a society can be very broad. It’s important that we focus on ESG issues that can have a direct and material impact on valuations and investment results, and where we as an investment manager can influence change in corporate behavior. Progress in one area directly supports the others, creating an ongoing cycle of development. There are three key aspects of our approach:
 

  • Our sector-specific ESG research investment frameworks emphasize the issues we believe will drive long-term value creation.
  • We complement our proprietary research with select third-party data inputs to round out our ESG views.
  • As active managers, we are able to adjust our ESG analysis to account for evolving situations and industry conditions.

In our view, Capital Group’s long-term focus and investment horizon provide it with an advantage as it relates to focusing on ESG issues. Our equity funds’ average holding period is three years — 71% longer than our peers.1 Compensation paid to our investment professionals is heavily influenced by results over one-, three-, five- and eight year periods, with increasing weight placed on each succeeding measurement period. This encourages a long-term investment approach that focuses on the long-term sustainability and viability of companies in their industry, society and environment. Our deep research, regular dialogue with companies and diversity of thought tend to lead us toward companies focused on creating long-term value. We understand that the enduring profitability and growth of a company are directly tied to its relationships with customers, employees, suppliers, regulators and the environment in which it operates.


Thinking in multi-year time frames also helps us identify and invest in companies strategically positioned to bring substantial change to the world. ESG is just as much about identifying opportunities as it is about understanding risks. Many elements of ESG are a natural fit with our investment process and have historically been a focus of our analysts and portfolio managers. In the last couple of years, we have expanded investments in our firm-wide approach to ESG integration, making the process more transparent and systematic, and enhancing the infrastructure so that we can continue to refine and further improve the process over time with new learnings as well as the evolution of industry best practices.


In 2020, we placed an enterprise-wide focus on what we call “investment frameworks.” Our investment analysts created more than 30 industry-specific ESG investment frameworks that capture the issues we believe to be material to each sector, help us understand how those issues affect companies financially, and enable us to measure and integrate those insights into our investment process. Analysts across Capital Group’s equity and fixed income investment units participated in these collaborative discussions. In all, Capital Group invested over 4,000 hours, integrating views from 200 investment analysts and 14 ESG specialists.


We were intentional about not covering every ESG issue, but on covering the issues that we believe are most material for that sector. This approach builds on one of our greatest strengths: a highly experienced group of analysts building perspective on long-term industry trends and the distinct potential and risks associated with each company.


Importantly, in these frameworks, we are seeking to measure and evaluate the risks and opportunities not fully captured by traditional financial metrics. These issues include long-term secular trends such as energy transition and inequality. We have multiple analysts who have followed a company through several managements and understand each company’s corporate culture and its strengths and weaknesses. This can be as important as financial metrics, as culture is not built in a single year. For example, can the company build a competitive advantage by attracting, retaining and promoting the right people? Can it increase consumer trust by providing safer products?


The U.S. health care services sector is a good example of our holistic, evidence-based approach to ESG. Research analysts sought to identify aspects that they believed were most material to the success of a company as a long-term investment. Analysts identified social topics as being the most material ESG issues within the industry. This meant a focus on consumer safety and product quality, affordability and access, and data security and privacy, all underpinned by strong management quality and accountability.


Zeroing in on material issues


In U.S. health care services, our analysts believe that value-based care (i.e., incentives aimed at keeping people healthy rather than additional fees for services) is the most sustainable model over the long term. Doctors in value-based care models tend to conduct more proactive patient outreach and emphasize preventive care and ongoing maintenance.


Material ESG Issue: Health and safety. Relevance in investment analysis. Companies differentiate through providing health care benefits and making employees feel safe, which can lead to a competitive advantage. Everyone is competing for workers. COVID-related additions. COVID-19 is an additional risk factor, with many cases tied to employees (essential workers) contracting the virus at work. Best practices. Provide wages and benefits beyond minimum standards, including tuition reimbursement, health care coverage, mental health care and child care resources. COVID-related additions. Provide needed sick time off, ensuring that no employee has an incentive to come to work sick.

As of March 2021

We believe this approach helps improve the health of the broader population, likely reduces costs and also increases patient satisfaction and retention. Beyond the conversations with management and visits to companies, analysts look at indicators such as customer satisfaction tracking and net promoter scores. Analysts also review and assess regulatory risk, including the potential for sanctions, warning letters, fines, restrictions and recalls.


Although we support industry-wide disclosure standards such as those set by the Sustainability Accounting Standards Board (SASB), having served on their investor advisory board, a majority of the information that we have gathered for our health care framework comes from unconventional data sources.


A differentiated ESG view


Our research efforts may cause us to occasionally disagree with ESG rating agencies. One major ESG rating agency, for example, rates a specific company in value-based care below that of its peers. The rating agency penalizes the company for publishing limited information on customer satisfaction rates and not establishing policies on emerging health risks such as obesity and environmental pollution. We take a different view and see the company as a pioneer in its space. By changing the incentive structure for doctors, this company encourages preventive care and contributes to better health outcomes overall, which we believe to be more material to the company’s long-term success as an organization and, therefore, for us as an investment.


An evolving process focused on better outcomes


We believe our persistent focus on ESG research is a critical component of our mission to improve lives through successful investing. But our work is not done. In a rapidly evolving global economy and society, material ESG issues can change quickly. We continue to regularly and systematically review and adapt our investment framework.


It’s a large commitment of time and resources, but we remain convinced that a materiality-based approach to ESG will reinforce the types of sustainable business practices that can drive better outcomes for our investors.


1 On average, the equity-focused American Funds hold their investments for 3.0 years, whereas their peers hold their investments for 1.7 years, based on the equal-weighted blended averages across each of the 20 equity-focused American Funds’ respective Morningstar categories as of September 30, 2020. Fixed income funds are not included in this calculation due to the differing nature of trading in the asset class versus equity investing.


Matt Lanstone is a global head of research and investing in ESG with 28 years of industry experience (as of 12/31/2020). He holds a bachelor’s degree first class in economics and accounting from the University of Bristol. 


Capital Group manages equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.

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