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Inside ESG: An analyst’s experience of the CFA exams

Aubrey Capital’s Jay Younger outlines what analysts learn (and miss) when gaining the certificate.

Inside ESG: An analyst’s experience of the CFA exams

 

What are the benefits of taking the CFA’s ESG exam? Jay Younger, an investment analyst at Aubrey Capital, responds to Nisha Long’s recent article with his own experience.

 

As Dr. Nisha Long’s highlights in her article, the lack of agreement on reaching a common ESG standard for the industry is becoming a challenge, and the lack of consistent corporate reporting exacerbates this.

Therefore, trying to ascertain ESG risks between companies and incorporating these into valuation methodologies can be complex. When determining valuation, in theory, adjusting a discount rate to reflect an appropriate cost of capital seems like a fair approach.

For example, a company that has strong environmental management processes could be rewarded with a higher valuation by reducing the cost of capital to reflect the reduced risk.

On the other hand, another company with poor environmental management processes could be penalised for not managing these negative externalities with a higher cost of capital and thus warrants a lower valuation.

Subjectivity

An investor can then decide whether a company is worth a certain price/earnings premium or discount to its peers due to ESG factors. This is a method from the study information provided by the CFA UK for the Certificate in ESG investing. 

However, we often find that this is too subjective a way to assess risk in that not only do valuations become easily distorted, but the focus also shifts away from what is actually important.

As investors we are focused on creating long term value, and therefore engagement with corporates is key, not a discounted cash flow model that spits out a buy, sell or hold recommendation based upon whichever discount rate is used.

Our approach is built on common sense, and we have avoided recent corporate scandals, despite these companies being scored highly by third-party ESG providers. While the companies in our portfolio display strong ESG credentials, we have engaged with smaller companies in order to enhance the disclosure.

Market experience

An example is MIPS, a Swedish company that has developed a helmet safety and brain protection system based on brain trauma research carried out by doctors at the Royal Institute of Technology in Sweden. This helps protect the brain from shock or concussion on impact by allowing for a very slight 10-15mm spin inside the helmet when the head hits the ground at an angle.

This company is making a serous contribution to the safety of individuals, particularly cyclists, construction workers, police and armed forces and those engaged in sport. However, some might argue that because of the lack of ESG disclosure, the company should trade at a discount to its current valuation.

We believe this is not at all pragmatic. Simply because a company does not disclose relevant ESG data does not mean it is not managing its ESG risks appropriately.

The smaller player problem

In general, smaller companies do not place a large emphasis on ESG disclosure because they have fewer resources. In this case, we spoke with management and have been reassured. Management does not want to create a report simply to keep investors happy, instead the group wants to integrate sustainability into all its products.

The current sustainability section in the report is a short-term compromise while the longer-term strategy is being developed. This strategy will focus on four key areas: employees, products, supply chain and MIPS’ own environmental impact.

We have not performed a complex valuation adjustment to reflect this, rather we prefer to have frequent dialogue with management about the progress. This allows us to prioritise long-term value creation in accordance with our investment philosophy as opposed to making speculative model adjustments and assumptions.

Long-term value

As such, we believe integrating ESG is not about tweaking financial models. It is about engagement, monitoring and constant dialogue with companies in order to create long-term value.

The Certificate in ESG Investing communicates this, but I felt the exam pushed for more complex valuation techniques and speculative assumptions which would overcomplicate and distract our focus away from what is important.

We appreciate consultants in this industry need to see evidence of process which is why these valuation methods are proposed. However, regular dialogue with management is sufficient, in our view, to satisfy the demands for ESG reporting and the longer-term goal of value creation. 

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