Fidelity International - The unstoppable ascent of sustainable investing

Key Points

• The crisis has accelerated the adoption of sustainable capitalism and companies are striving to protect and support employees, customers, suppliers and communities.
• At the height of recent market volatility, securities issued by companies at the top of Fidelity’s proprietary ESG ratings scale on average outperformed those with lower ratings.
• As asset owners start to target sustainability metrics beyond traditional financial obligations, they drive managers of that capital to invest with those principles in mind - creating something of a virtuous circle.

The bottom line isn’t the top priority that once was. In decades past, corporate earnings calls focused on quarterly earnings per share, performance relative to past quarters and future expectations. These numbers express the priorities of shareholder capitalism and its measures of corporate success.

While valuation metrics are unlikely to change, we’ve heard CEOs and CFOs demonstrate a very different focus on their earnings calls since March. They are striving to communicate different numbers, which represent their efforts to protect and support employees, customers, suppliers and communities.

The Covid-19 crisis has accelerated the adoption of sustainable capitalism, in particular on matters related to the social good which may ultimately prove to be ground-breaking. There is growing recognition in the corporate world that its existence as a system for allocating resources is based on an implicit licence granted by society, one that can only be strengthened by seeking win-win, rather than win-lose, outcomes.

Mapping the transformation on-the-ground

We have been able to map this transformation of corporate purpose via our monthly survey of more than 140 of our analysts worldwide. For example, over half of the responses to the May Fidelity Analyst Survey indicated an increase in company plans to step up focus on workers, consumers and the wider community as a result of the pandemic.

Across sectors and regions, our analysts said that the health of staff has been at the forefront of managements’ minds, and companies will devote more attention to employees safety and wellbeing in the future. The survey also found that for some companies, demonstrating good corporate citizenship and support for the communities in which they operate is now an essential part of building and sustaining brand equity post-crisis.

Corporate action and sustainable capitalism

Listening to what companies are saying is useful, but tracking what they actually do is better. Many listed companies are changing the way they allocate funds. They are reducing share buybacks, slashing dividends and cutting executive bonuses, and instead are guaranteeing jobs and providing extended paid sick leave, enhanced health coverage and child care.

This focus on employee safety and improving employee satisfaction is a recognition that the increased productivity and goodwill earned from these measures will help companies survive and thrive in the long run, as illustrated by the examples picked out by our analysts below:

• Mengniu throws lifelines to its supplier chain

Chinese dairy producer China Mengniu has kept its commitment to buy milk from dairy farms and honoured its procurement obligations through the crisis, despite lower expected end-demand. Mengniu also provided zero-interest funding to support farms with temporary financial liquidity problems. Not only will this help farmers survive, but it also stops a lot of raw milk from going to waste. Mengniu plans to convert this raw milk to milk powder to store as inventory for future use. This will hurt margins in the near-term, but crucially it protects its supply chain and the sustainability of the business over the long-term.

• Salesforce – 360° stakeholder engagement

At the height of the crisis, Salesforce sent an aeroplane loaded with PPE to New York City including masks, gloves and aprons. It has since launched work.com, a platform for businesses to get back to work safely following the pandemic. The company will charge a nominal fee for the platform, which will focus on on-site visitor management, business continuity and supply chain management.

Sustainability and investment performance

A sustainable company, or industry, is one that lasts, providing investors with years of earnings. The methods used to pick out these companies are an evolution of the traditional long-term fundamental investment processes, rather than a break from them.

History suggests that lasting returns go hand-in-hand with management teams that exercise good judgement around business risks and pay attention to broader societal good. A good example that has stood the test of time is the contrast between Merck and Enron.

In the 1980s, Merck donated anti-parasitic river blindness medicine to developing countries at a cost to itself of millions of dollars. The move helped earn Merck the top ranking in Fortune’s most admired company list for seven consecutive years between 1987 and 1993 and it remains a blue-chip pharmaceutical stock in the S&P 500 today. Enron, of course, did not survive its own fatal governance flaws.

The sustainability theme has matured as an analytical approach, providing investors with a globally accepted vocabulary and a body of knowledge with which to analyse corporate performance. Fidelity has developed our own proprietary sustainability ratings to capitalise on and advance that body of knowledge, assigning the companies we cover an A-E rating based on their performance against sustainability criteria.

Positive feedback loops

Our own conversations with clients suggest that sustainability has become a core component of capital allocation decisions. This raises the prospect of a systemic behavioural shift turning into something of a virtuous circle. As the owners of capital start to target sustainability metrics beyond their traditional financial obligations, they drive the managers of that capital to invest with those principles in mind.

In turn, those professional investors put more pressure on corporate management to raise their standards, boosting the expectations of the capital owners for better sustainability outcomes.

We expect the strong demand pull for sustainable funds to continue, if not strengthen as a result of Covid-19. Funds flow data shows that global flows into sustainable funds totalled US$46bn in the first quarter of 2020 versus overall fund outflows of US$385bn. This dynamic held true even during the peak of the crisis in March, when European investors put US$33bn into sustainable funds against an overall fund outflow of US$163bn, according to Morningstar data.

Implications for the future

These developments will have both intended and unintended implications for risk assets. On one hand, some companies could face lower profit margins due to higher labour costs, costs for compliance with environmental regulations and cost inflation stemming from localised supply chains. More sustainable private consumption patterns and adherence to circular economy principles could also constrain top line revenue growth. Taken together, this could result in more gains in the real economy at the expense of financial assets.

On the other hand, as a greater number of companies focus on the long-term sustainability of their business models, picking the right investments should still lead to consistent and high returns. It’s important to remember that compounding returns from cash generating, long-duration investments with high survival rates are the bedrock of long-term investing.

In the near-term, investments in sustainable companies should benefit from improving valuations for high ESG scores, augmented by outsized fund inflows. These companies will also have better access to lower cost and longer-term funding, an advantage that serve them especially well, if and when rates begin to rise.

It is likely that the extreme and tragic experience of the Covid-19 pandemic has resulted in a permanent change to the mindset and attitudes toward sustainable capitalism. If the door to combining corporate purpose and the common good was open a crack before the crisis, the events of the last five months have thrown it wide open.

Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration onbly.

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