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Welcome to Soundbites – weekly insights on market trends, and investment strategies, brought to you by Investment Executive, and powered by Canada Life.

For today’s soundbites, we discussed environmental, social and governance issues with Ross Cameron, a portfolio advisor and analyst with Northcape Capital. Ross is based in Tokyo, and we started by asking about the limitations of third-party ESG research.

Ross Cameron (RC): The problem with ESG benchmarks is that kind of approach can quickly lead to a box-ticking exercise. ESG is not something that should be outsourced. This absolutely needs to be a core, integrated part of the manager’s investment process. One of the big benefits is to actually influence company behaviour. And the fund managers themselves, considering investing hundreds of millions of dollars in the company, are in the best position to do this. They can engage with the company on ESG issues to an extent that third-party ESG research houses can’t.

About the challenge companies face conforming to ESG principles.

RC: The biggest issue facing companies is that the definition of what constitutes acceptable behaviour is actually in a state of constant change. The goal posts for the companies are changing. Now, that’s a good thing, because we’re constantly pushing the companies to engage in better and better behaviour. But what it means for the company management is behaviour that five years ago was the industry norm, is no longer acceptable. That’s a huge challenge for companies.

Why hitting environmental targets is the hardest part of ESG.

RC: Companies generally have good control over their governance and social practices – the S and the G. These are internal to the company. Environmental is much, much more difficult because much the supply chain is outside of the company. And the supply chain is extremely complex. It is very difficult for companies to have the same level of control. So, if you think of a consumer products company like Apple or Tesla, they both use lithium-ion batteries. A key component is cobalt, and there’s huge environmental and social issues with the mining of that cobalt. So, environmental isn’t just about Tesla’s factory or Apple’s plant in California. It is about all the components that go into those products.

Is this why environmental ratings tend to be subjective?

RC: That’s exactly right. And again, if you look at Tesla, one ESG ratings house rates Tesla as one of the very best companies in the world for its environmental score, and another leading investment house ranks Tesla as one of the very worst. It’s a very high-quality environmental company in that it’s reducing emissions with electric cars. But on the flip side, the cobalt in the batteries is creating enormous environmental degradation. So, it depends on your perspective.

What regions he likes for ESG.

RC: In terms of the areas that we think are really improving: Taiwan and [South] Korea stand out. There is a very good social buy-in in these countries. So, we’re very excited about some of the initiatives that are going on in those two countries in particular. They offer investors an opportunity to ride a very attractive improving ESG tailwind.

And what sectors.

RC: One of the most interesting areas for exposure to environmental change is technology. Companies like Samsung SDI in Korea have the opportunity to massively change the way in which we use resources. So, we’re focused on technology companies that can drive efficiencies. On the other side, I think materials will struggle. So many of the materials that are used in our consumer products, it’s not just a question of environmental degradation, it is also appalling conditions for the workers. And so, materials really has a challenge.

And finally, what’s the bottom line here?

RC: ESG really matters. I mean, of course it matters because we want to invest in companies engaging in good behaviour. But ESG also matters to investment returns. If you look at the performance of the MSCI all-countries world index ESG leader index, that index has outperformed the general index by more than 1,000 basis points since 2008. So, the big message is we should want to effect change through our capital allocations. And we will be rewarded for doing so because over the last decade-and-a-bit, strong ESG companies have significantly outperformed their peers.

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Well, those are today’s Soundbites, brought to you by Investment Executive, and powered by Canada Life.

Our thanks again to Ross Cameron, portfolio advisor and analyst at Northcape Capital.

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