Sustainability Program Can Increase Target Price by 15%

The impact of ESG value driver analysis on investment decisions
Sustainability Program Can Increase Target Price by 15% Sustainability Program Can Increase Target Price by 15%
Publ. date 19 Apr 2016
The valuation impact of sustainability can be very high. ESG based value driver analysis led to a target price impact of -19% at Anglo American and +23% at Chr. Hansen. However, when talking to Investor Relations executives and Board members of listed companies, a frequently heard statement is “Why bother, our investors are not interested in sustainability”. This claim is sourced from the observation that there are few questions in shareholders meetings and earnings calls that address the topic. But how is that possible with the level of assets under management of ESG integrated funds rising beyond €6 trillion in Europe alone?

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It is evident that ESG integration is a relatively new discipline within the asset management sector. Many investors, like (too) many listed companies, are still selecting  a communication angle to disclose and analyse the sustainability performance of their portfolio by regarding ESG data as a late add-on to their basic analysis. But increasingly, empiric evidence is found that things are changing. And for frontrunner companies, this represents a significant opportunity to differentiate.

The example of Robeco Asset Management

Through its culture of active ownership and fundamental analysis, Robeco Asset Management illustrates that a profit-oriented SRI strategy can outperform the market once ESG factors are linked to the value drivers. Over the past two years, the company has applied  its “Value Driver Adjustment” approach in 127 investment cases leading to an average valuation change of 5% of the target price of the stocks analysed based upon key ESG factors. In 39% of cases, this approach led to a positive change in the stock’s target price and 13% to a negative change. Overall, 52% of the cases were impacted with the target prices changes ranging from -23% to +71%.

Example: Chr. Hansen (November 2014) – ESG highlights competitive advantage

  • ESG issue and explanation: Food ingredients manufacturer Chr. Hansen scores low with the ESG rating agencies but this is more a reflection of disclosure than performance. In our view, Chr. Hansen is strong on ESG both from a top-down (health & wellness theme) and a bottom-up perspective (very strong innovation management and strong in health & food safety management and supply chain management).
  • ESG segment view: Food ingredients benefit from food manufacturers’ needs to battle obesity and reduce their fat, salt and sugar content.
  • Impact on investment decision or performance: We think Chr. Hansen enjoys a competitive advantage from the aforementioned ESG factors. This resulted in a positive impact on our value driver assumptions (sales growth and margins) and a 23% higher target price. We bought the stock.

Example: Anglo American (May 2014) – competitive disadvantage from ESG keeps us away

  • ESG issue and explanation: Mining company Anglo American has a high score with ESG rating agencies and does indeed score well on many dimensions. However, upon closer inspection it scores rather poorly on highly material issues such as Management of Local Stakeholders, Country Exposures and Occupational Health and Safety.
  • ESG segment view: Metals lose out to chemicals. Within metals, extra caution is warranted on high risk countries and labor intensive ores.
  • Impact on investment decision or performance: We think Anglo American suffers from a competitive disadvantage on the abovementioned ESG factors, which drove down our margin assumption and resulted in a 19% negative target price impact, and insufficient upside to warrant a BUY recommendation. The stock was not bought.

Table 1: Examples of Anglo American and Chr. Hansen – Source: Robeco

The Value Driver Adjustment approach in 3 steps

The Value Driver Adjustment approach consists of a straightforward three-step process as conducted by the sustainability analysts of Robeco.

  1. Identify and focus on the most material issues for the industry
  2. Analyse the impact of these material factors on the individual company
  3. Quantify competitive (dis-)advantages to adjust value driver assumptions

Quantification of the (dis-)advantages is done in different areas: sales growth, margin impact, capital, and risk. After discussing the results of the analysis with the equity analyst, the summary of the impact of the analysis could look as follows. In this example from the Chemical sector, it resulted in a 15% positive target price change.

Table 2: Value Driver Adjustments for a chemicals company

So why are investors not asking more questions?

With a only a small portion of SRI investors taking an integrated ESG approach and an average impact of 5% of the target price, it seems no more than commonsense that in comparison to topics such as profit protection programs, financial restructuring and strategy execution, few questions are asked on sustainability in the earning calls. However, this does not imply that companies should remain impassive in this area – on the contrary. As a recent Harvard Business School paper (Khan et al. ,2015) confirmed, it is not the overall sustainability profile of a company that’s crucial to investment performance and value drivers, but the most material factors.

The percentage of ESG integrated funds linking ESG to value drivers is on the rise as the market is smartening up.  The examples of Anglo American and Chr. Hansen demonstrate that it could prove a very worthwhile exercise for sustainability frontrunners, as significant target price adjustments are a realistic possibility feasible.

Are you already taking a pro-active approach?

As a result, the way to go for listed companies that want to differentiate themselves on ESG factors is to better facilitate the analysts. Hand them the right material. Design and deliver a value-driven analysis that emphasizes your ESG-performance in value beyond your (already impressive) sustainability metrics.

To get there, the suggested actions to take are:

  1. Develop a high-quality fact-based materiality analysis of your own business.
  2. Next to the risks from these material issues, analyse the margin impact and growth potential turning your materiality matrix into a full kaleidoscope (see also article below "Mobilizing your Board...").
  3. Publish clear progress numbers on issues that drive value most and are therefore most likely to trigger target price change;  your top materialities. The top 5 issues within the sample of 127 cases at Robeco are innovation management (39%), corporate governance (27%), environmental management (20%), supply chain management (17%) and energy efficiency (16%).
  4. If an extra push is still required, engage your Senior Management on talking sustainability as a part of strategy; for instance by mapping your company’s must-win-battles with the UN Sustainable Development Goals.

 

Is your company looking to improve its ESG performance or looking for more street-cred from its ESG communications? Please contact Josée van der Hoek, Partner, at josee@finchandbeak.com or +31 6 28 02 18 80.

This article was based upon “Integrating ESG into valuation models and investment decisions: the Value Driver Adjustment Approach” by Dr. Willem Schramade, Sustainability & Valuation Specialist, Global Equities at Robeco Asset Management, which will be published in a forthcoming issue of the Journal of Sustainable Finance & Investment. For more case examples or details about the methodology used, please download the pdf-paper at the top of the article.

Image source: Mike Motzart, Flickr

About Jan van der Kaaij

Sustainability expert in strategy development, DJSI and sustainable innovation, with a hands-on approach and always committed to go for the max. | jan@finchandbeak.com 

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