Robert Hamwey explains what investors are looking for when seeking out sustainable enterprises.
Investors are increasingly looking to sustainable enterprises to produce future outperformance in portfolios. What rationale supports this search and how can sustainable enterprises be identified?
An enterprise's earnings performance is no longer governed mainly by financial figures in the corporate accounts. In today's global, highly competitive markets, strengthened regulatory regimes and growing stakeholder expectations make economic, environmental and social business factors increasingly important. Sustainable development is said to occur when these factors are integrated into corporate decision-making. A sustainable enterprise is one that attaches importance to managing these factors through corporate strategies and actions. It does so to gain competitive advantages, leading to improved performance relative to less sustainable competitors and providing enhanced potential for sustained long-term growth.
Sustainable enterprises are generally multinationals or mature and established players in their markets. Benefiting from acquired market wisdom and long-term vision, they can afford to spend the time and resources needed to explore scenarios for future viability, and to develop strategies needed to adapt to them.
From an investment perspective, how can sustainable enterprises be distinguished from their unsustainable neighbours in the enterprise universe? A combined series of four investment screens can be used to effect sustainable development investments:
q financial: examining the underlying financial status of enterprises;
q economic: identifying opportunities and barriers to growth related to regional, sectoral and global trends;
q environmental: identifying relevant environmental issues and assessing the environmental performance of enterprises, and
q social: investigating the ethical conduct of enterprises and their commitment to social responsibility with stakeholders.
Conventional investment analysis typically applies only to the first, or first two, of these screens. Here, analyses go further by applying all four. Together these investment screens pass only equities of sustainable enterprises from the universe of equities existing in a targeted regional or global market.
Economic analysis evaluates an enterprise's ability to generate economic value, growth prospects for sales of its goods and services, and evolving trends within the larger market it serves. It is made at the enterprise, sector and global economy levels. At the enterprise level it begins with an assessment of an enterprise's economic value added" (EVA - see IPE September) using data from corporate financial statements. Since EVAs are positive only for firms that have a return on capital greater than its opportunity cost, they provide an overall measure of how well an enterprise has created shareholder value.
Sector and industry studies can uncover business areas where the greatest growth is expected over medium- to long-term time horizons. Sustainable development investment criteria require that enterprises:
q be in growing markets well below saturation levels;
q have growing market shares for goods and services;
q be protected from competitors by significant barriers to entry (economies of scale, product differentiation, exclusive distribution channels, etc.);
q have high margins relative to competitors;
q be without capacity, labour or supply constraints, and
q benefit from strategic partnerships and multinational joint ventures.
At the highest level, global economic analysis investigates how regional and global economic trends may impact on an enterpriseís growth prospects. Criteria need to be developed to highlight favourably those firms that should experience net benefits, and raise warning flags for those that may encounter problems. Relevant trends to be considered are numerous, ranging from per capita GDP growth and employment levels to trade and foreign direct investment flows. Once defined, screening criteria can be applied in two phases. In a first phase, through a high-level checklist approach, enterprise activities are evaluated against known trends. Potential areas of opportunity and threat are noted. In a second phase, detailed analysis would be required for areas where negative impacts of trends seem significant.
Statements of corporate strategy must also be compiled to provide an idea of corporate direction and vision in both the short and long terms. The strategic posture of an enterprise indicates how much economic awareness it has, and how fully it will be able to exploit possibilities uncovered in sectoral and global economic analyses. Risk assessments for an enterprise's earnings estimates should be made. Finally passing through the economic screen is a set of enterprises with good underlying financials, and strong long-term earnings potential at acceptably low risk.
In today's world, businesses large and small are confronted with environmental challenges. Increasingly, government-imposed regulations, green consumer pressures and the realities of limiting resource consumption to reduce costs together have an impact on the sustainable long-term growth of companies. The sustainable enterprise thus has a past record of good environmental performance and established environmental policies implemented through a world standard Environmental Management System (EMS). EMAS and ISO 14000 are prominent standards with essential environmental impact assessment, eco-efficiency and environmental communications elements.
An enterprise with a well-managed and aggressive EMS is expected to accrue many balance sheet benefits. These include costsavings, increased sales and profit margins, and reduced regulatory and liabilit y charges. All act to drive shareholder value upwards. On the other hand, when environmental objectives are pursued to excess under poor management, financial performance may suffer due to the careless destruction of shareholder value. Shareholders must verify that an enterprise's environmental management activity is financially sound.
Examining the environmental financials of an enterprise requires that the costs and benefits of its environmental investments be quantified, and net benefits result. Basic input data are the projected cash flows associated with each investment. For the ensemble of environmental investments made by the enterprise, their aggregate discounted cash flows can be used to calculate a free cash flow for environmental investments (EFCF). The EFCF equates to net shareholder value deriving from environmental investments. Only when this 'environmental' shareholder value is positive, can equity in the enterprise pass through the environmental screen for sustainable development investments.
Affecting the level of ethics and social responsibility is the degree of partnership a firm seeks with its stakeholders: employees, shareholders, clients, suppliers, competitors and communities. Strong partnerships create a stable and supportive environment that can facilitate sustained growth. In general, competitive enterprises with high long-term growth expectations increasingly rely on valued partnerships to propel growth, while firms in less competitive markets where growth opportunities are often limited, do not. Investments made in enterprises with high levels of social responsibility thus tend to correlate well with future growth in shareholder value.
For an enterprise to be accepted for sustainable development investment, its publicly pronounced ethics policy, and importantly, its demonstrated actions, should be benchmarked against an industry ethics standard such as the well-known Caux Principles. Progressive social standards include:
q ethical business conduct;
q ethical goods and services
respect for its employees, clients and suppliers;
q improving the quality of life and encouraging a participatory approach to local decision-making in communities where it operates;
q promoting social advancement, job creation, human rights and democratisation in national arenas where it has a major presence, and
q supporting principles of competitive open markets and free trade in its national, regional and global settings.
Whatever standards are employed, when an enterprise's policies and actions are in conflict with social standards, the enterprise can be contacted to clarify reasons for observed inconsistencies, and possibly reform social policies. When concerns can be satisfactorily resolved, equities pass through this last in the set of sustainable development fund screens, and investment can proceed.
Dr Robert Hamwey is an associate professor at the International Academy of the Environment in Geneva"