Finding Value in ESG (1Q 2023)
7 min read
ESG is a key component of bottom-up fundamental analysis. Engagement and improvement can drive value creation and lead to successful investment outcomes.
Environmental, Social and Governance (ESG) rose to prominence in the asset management industry relatively unquestioned. Recently, opinions on the topic have become increasingly polarized. We do not subscribe to either extreme: that investors should pursue special interest group agendas no matter the cost to companies, or that considering ESG is damaging to investment outcomes. Against the backdrop of the ESG debate, we thought it would be helpful to get back to the foundations of ESG and why we continue to pursue ESG integration.
Fundamentally, this comes down to the philosophical alignment between the principles of a value investor and ESG integration. ESG integration simply means considering a sub-set of issues that can become financially material and, in such cases, become relevant to investment outcomes. As such, our investment research would be incomplete without appropriate consideration of material ESG issues. ESG integration at Pzena is about fully understanding the value opportunity at stake for a given company and, through active ownership, engaging to create long-term value.
Below are some of our core philosophical beliefs as a value investor, and we highlight the inherent compatibility with ESG integration.
1. Temporary Difficulty
Undervalued stocks typically experience some kind of difficulty; hence they trade at a discount to the rest of the market. The possible reasons for a depressed valuation are numerous, including that the company faces ESG issues or has mismanaged its exposure to ESG risk. Fundamental bottom-up research enables us to make informed judgements about whether a company’s difficulty (ESG or otherwise) is temporary or permanent, and whether we can envision a path to earnings recovery.
2. Improvement Opportunity
Once the source of difficulty has been identified, value investors must assess the embedded opportunity. Value investing offers an opportunity to buy a good business “on sale”. Usually, the opportunity exists because the business is undergoing a temporary setback, such as declining earnings. For those companies that are also ESG laggards, part of the investment opportunity can be the potential for future improvement in material ESG dimensions, which can benefit business constituents, including shareholders. In this sense, we do not believe in inherently “bad” or “good” ESG companies. What matters is the embedded opportunity to improve.
Hon Hai
In December 2022, we made the decision to add Hon Hai to the Opportunity List given the escalating number of labor-related controversies. As a mobilizer of a large low-cost labor force, labor is both a critical business resource and potential risk factor for Hon Hai. From
a business perspective, ensuring a supply chain that meets international standards is critical to the long-term success of Hon Hai. We therefore consider social issues a tail risk that we need to continue to monitor. Several highly publicized labor-related controversies have occurred in the last three years. While we are disappointed to see a recurrence of labor-related issues, we are pleased that Hon Hai is now more proactive in disclosing information and discussing these incidents with shareholders. We maintain an ongoing dialogue with the company on labor issues and continue to assess the risk of Hon Hai losing market share.
Alibaba
Alibaba has a history of governance lapses which contributed to our decision to add it to the Opportunity List in Q4 2021. These have included issues related to business ethics and related party transactions, as evidenced by the partial transfer of control of Ant Group to Jack Ma in 2011. Given Alibaba’s history, we feel that continued responsiveness to shareholder concerns and the passage of time without incident will be the best measurement of their progress on ethics and governance.
CONCLUSION
At Pzena, our focus will always be on the material issues facing a company, ESG or otherwise, that may be contributing to current underperformance. If those issues are temporary and/or can be remediated, the company may be an interesting investment opportunity. The Opportunity List consists of a subset of our portfolio companies where ESG issues are among the most material issues facing the company. Improvement in these ESG issues, aided by our engagement efforts, could therefore lead to improvement in company earnings. However, there is no guarantee of ESG improvement for companies on the Opportunity List and they may remain on the Opportunity List for a range of timeframes. Regardless of outcome, we maintain that the most important thing is to continue to advocate for change if we believe it is in the interests of long-term shareholders to do so.
FURTHER INFORMATION
These materials are intended solely for informational purposes. The views expressed reflect the current views of Pzena Investment Management (“PIM”) as of the date hereof and are subject to change. PIM is a registered investment adviser registered with the United States Securities and Exchange Commission. PIM does not undertake to advise you of any changes in the views expressed herein. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance is not indicative of future results.
All investments involve risk, including loss of principal. Investments may be in a variety of currencies and therefore changes in rates of exchange between currencies may cause the value of investments to decrease or increase. The price of equity securities may rise or fall because of economic or political changes or changes in a company’s financial condition, sometimes rapidly or unpredictably. Investments in foreign securities involve political, economic and currency risks, greater volatility and differences in accounting methods. These risks are greater for investments in
Emerging Markets. Investments in small-cap or mid-cap companies involve additional risks such as limited liquidity and greater volatility than larger companies. PIM’s strategies emphasize a “value” style of investing, which targets undervalued companies with characteristics for improved valuations. This style of investing is subject to the risk that the valuations never improve or that returns on “value” securities may not move in tandem with the returns on other styles of investing or the stock market in general.
This document does not constitute a current or past recommendation, an offer, or solicitation of an offer to purchase any securities or provide investment advisory services and should not be construed as such. The information contained herein is general in nature and does not constitute legal, tax, or investment advice. PIM does not make any warranty, express or implied, as to the information’s accuracy or completeness. Prospective investors are encouraged to consult their own professional advisers as to the implications of making an investment in any securities or investment advisory services.
The specific portfolio securities discussed in this presentation are included for illustrative purposes only and were selected based on their ability to help you better understand our investment process. They were selected from securities in one or more of our strategies and were not selected based on performance. They do not represent all of the securities purchased or sold for our client accounts during any particular period, and it should not be assumed that investments in such securities were or will be profitable. PIM is a discretionary investment manager and does not make “recommendations” to buy or sell any securities. There is no assurance that any securities discussed herein remain in our portfolios at the time you receive this presentation or that securities sold have not been repurchased.
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This marketing communication is issued by Pzena Investment Management, Ltd. (“PIM UK”). PIM UK is a limited company registered in England and Wales with registered number 09380422, and its registered office is at 34-37 Liverpool Street, London EC2M 7PP, United Kingdom. PIM UK is an appointed representative of Mirabella Advisers LLP, which is authorised and regulated by the Financial Conduct Authority. The Pzena documents are only made available to professional clients and eligible counterparties as defined by the FCA. Past performance is not indicative of future results. The value of your investment may go down as well as up, and you may not receive upon redemption the full amount of your original investment. The views and statements contained herein are those of Pzena Investment Management and are based on internal research.
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In New Zealand, any offer is limited to ‘wholesale investors’ within the meaning of clause 3(2) of Schedule 1 of the Financial Markets Conduct Act 2013 (‘FMCA’). This document is not to be treated as an offer, and is not capable of acceptance by, any person in New Zealand who is not a Wholesale Investor.
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Consent under the Control of Borrowing (Jersey) Order 1958 (the “COBO” Order) has not been obtained for the circulation of this document. Accordingly, the offer that is the subject of this document may only be made in Jersey where the offer is valid in the United Kingdom or Guernsey and is circulated in Jersey only to persons similar to those to whom, and in a manner similar to that in which, it is for the time being circulated in the United Kingdom, or Guernsey, as the case may be. The directors may, but are not obliged to, apply for such consent in the future. The services and/or products discussed herein are only suitable for sophisticated investors who understand the risks involved. Neither Pzena Investment Management, Ltd. nor Pzena Investment Management, LLC nor the activities of any functionary with regard to either Pzena Investment Management, Ltd. or Pzena Investment Management, LLC are subject to the provisions of the Financial Services (Jersey) Law 1998.
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