ESG Focus Should Be Yours Too

There is widespread misunderstanding about investing in the share market and risk, not helped by gung-ho declarations such as "without risk, no gains".

However, the simple truth is that putting money into shares already equals taking a big leap up on the risk ladder.

One need not add another layer of additional risk. Successful investing is closely correlated with assessing and reducing risk. This is what makes investing in the share market different from having a go at the metropolitan casino.

One additional factor is that share markets, similar as the weather outside, morph through various stages of risk vulnerability. There are times when everything seems hunky-dory and bad news has a lesser chance of impacting negatively on our investment choices; that's when risk taking more often than not is being rewarded with handsome returns.

Other times there appears to be no end to negative trends and bad news flow. Right now, I believe, we are somewhere in between these two opposing statuses.

It would take a Grand Optimist to assume share market indices will soon rally back to the highs from only a few weeks ago, which I think is now unlikely given the focus has shifted to decelerating global growth and rising bond yields, an unfavourable combination for equities likely to stick with us for longer.

Avoiding Bombs

For our investment portfolios, this means avoiding bomb shells has become even more important as the winners won't be able to compensate for the losses incurred from vulnerable losers taking a big hit.

I am not solely referring to speculative micro cap propositions. Lend Lease (LLC), a member of the ASX50, has just lost in excess of -23% in a couple of days only on the back of more write-downs from troubled engineering contracts and general risk-off selling.

Corporate Travel (CTD) shares are still down -27% since VGI Partners went short and issued an explosive attack on the company's communication with investors, including subpar corporate governance and opaque accountancy.

Shares in James Hardie (JHX) are now -18% lower than when the company released its quarterly update last week, revealing yet another disappointment. They had already lost -14% from their peak earlier in the year prior to this latest punishment.

RCR Tomlinson (RCR) whose shares were trading at $4 at the beginning of the calendar year has just requested yet another trading halt. The previous trading halt occurred on July 30, lasted for a whole month and uncovered -$57m in write-downs on two solar farm projects in Queensland. The company was subsequently forced to raise $100m in fresh capital at $1 per share. The CFO and CEO are now gone. The shares traded last on $0.87.

These are only a few examples from recent days. There are plenty of share prices out there that have equally felt the impact from portfolio rotation and retreating liquidity, though this should not obscure the fact there are different types of risk at play at the moment; apart from general share market risk triggered by macroeconomic events, there remains the observation that some individual stocks are simply riskier than others at the micro-level.

Pay Attention To The Past

Using broad filters such as small caps versus large caps, or cyclicals versus defensives can be a great starting point to reduce portfolio risk, alongside potential over- and under-valuations, but it doesn't necessarily cover enough ground to avoid the next shock announcement a la Lend Lease or James Hardie, or possibly worse.

One additional factor investors can use is past indications and performance. This is not the first time James Hardie issued a disappointing market update and Lend Lease first acknowledged it had uncovered some operational problems in its engineering division late last year.

While it is much easier in hindsight to draw tough conclusions, just about everybody was taken by surprise by the magnitude of Lend Lease's engineering problems, and this most likely includes group management.

This is not about "knowing", this is about weighing up the overall risk profile inside an investment portfolio that is already subjected to extreme volatility and plenty of uncertainties at the macro level. One way to protect yourself from knee-deep losses and sleepless nights is through having a safety net of cash, but decisions need to be made about where to raise this cash from.

Investors need not look further than the share price of Fletcher Building (FBU), still trading near five-year lows, having gone through a similar troubled experience as is today the case at Lend Lease and RCR Tomlinson. And who can forget this is what finished off the once highly regarded Forge Group?

I am by no means suggesting Lend Lease and/or RCR Tomlinson are about to go out of business, but there is enough anecdotal evidence that the emergence of problems -small or big- is often a reflection of processes, corporate culture and execution inside a listed business.

Remember when Vocus (VOC) was experiencing mass exodus from middle management staffers? The share price is a lot lower now, and so are the company's general standing, reputation, shareholders' satisfaction as well as the group's operational performances.

Bad Versus Good Companies

In recent times I have come across numerous negative media reports about European budget airliner Ryanair. It seems to me, the founder-operator is fighting wars with everyone from his own pilots to the rest of his personnel, baggage handlers, airports, and regulatory authorities. Even the passengers are unhappy.

How can such a business continue to reward its shareholders? The obvious answer is, of course, it cannot. At some point all the bad vibes and internal frictions will translate into bad news, and the share price will respond accordingly. Judging from Ryanair's share price over the past twelve months, this process has already well and truly kicked in.

In similar vein, the Deepwater Horizon oil spill that caused the BP share price to crash in April 2010 had been preceded by a number of problems with smaller projects that essentially indicated the company was not on top of its operational risk management.

As things stand, problems in the Gulf of Mexico caused eleven human casualties, on top of the largest marine oil spill impact in history. The BP share price is still a long way off from its level prior to the disaster.

ESG Focus; A New Tool

The answer to how best to avoid any of such idiosyncratic disasters directly affecting our investment portfolios seems to be through using an extra filter; one that is increasingly gaining traction among professional investors is the so-called "ESG" filter. ESG stands for Environmental, Social & Governance and is sometimes referred to as "green", "ethical" or "sustainable" investing.

Let's not start off on the wrong footing here: ESG is not a Trojan horse for world peace loving, tree hugging, anti-capitalism hippies. The reason why the concept is rapidly becoming more popular around the world is because investors increasingly are coming to the conclusion it is an effective tool to distinguish lower quality operators from higher quality companies, and higher quality companies are better for shareholders, even without unpredictable disasters.

Such conclusions are supported by a growing number of academic studies into the subject.

Let's be brutally honest about this: a company that adheres to the highest moral and legal standards, delivers excellent products and services, takes good care of its staff, and treats its customers well, such a company most likely will also prove a more rewarding investment for shareholders. Using ESG simply gives investors one extra tool to identify such gems, and to distinguish between lower and higher levels of corporate quality, which equals investment risk.

Also, there is no reason as to why using this extra layer of insight should remain the exclusive domain of institutional investors only. FNArena is currently preparing for the addition of a dedicated "ESG Focus" news section on its website, to be officially launched later this month.

Few Observations

Leading into the next addition to our news service, I thought I'd share a few thoughts and observations about ESG and the Australian share market:

-Earlier this year, successful online retailer Kogan (KGN) was caught out trying to offload shares on behalf of core management, including founder Ruslan Kogan, on the back of a press release that appeared to have only one aim; to get the share price up while stockbrokers were trying to offload stock.

This might well be crowned 2018's worst case of bad corporate governance in Australia. I suspect these events are one major reason as to why the share price has since collapsed from nearly $10 to now below $3. Admittedly, the company has disappointed investors since, while management did sell some shares; both would have been contributing factors as well.

-Harvey Norman (HVN) chair and founder Gerry Harvey likes to deride hedge funds that take short positions and everybody who criticises management and the company, really, but it can hardly be denied the company's accounting hides liabilities to and from franchise operators and Gerry himself decides on frivolous investment endeavours, such as the Coomboona Dairies, which should arguably be done on a personal leve and not through the listed Harvey Norman, ultimately forcing shareholders to pay for the investment failure.

Australia has a long legacy of listed family businesses being run as if they are still 100% family owned, long after shareholders have come on board through a public listing. I don't like either of these companies, and on my long-standing observation, ultimately these vehicles (with the wrong prime focus) do not provide good outcomes for shareholders in the long run.

-There was an overwhelming majority who thought a Royal Commission to hold the banks to account would be a gigantic waste of everybody's time and government resources, but the result proved the exact opposite. In the cases of AMP (AMP), IOOF (IFL) and Freedom Insurance (FIG) there are some very harsh lessons to be learned by value investors now regretting only looking at the short-term financials.

Cheap value alone does not a rewarding investment make. All three companies would score low on any decent ESG assessment. The same case can be made of the banks who truly dug their own hole and might now have to face the consequences for years into the future.

-What do the numerous outages tell us about what is going on internally at Telstra (TLS)? Or the fact that a BHP ((BHP) train loaded with iron ore, but without its driver, takes off and cannot be stopped other than by de-railing it (effectively demolishing the train) only three years after that costly Samarco dam-disaster in Brazil?

-Also, anyone else noticed how both BHP and Rio Tinto (RIO) have quietly extricated themselves from "dirty" coal?

-Macquarie researchers recently put a human capital management filter through the companies covered by the firm in Australia, essentially assessing companies on how well they are in managing the labour part of their businesses.

Coming out positively, while also carrying a positive rating from Macquarie analysts, were Aristocrat Leisure (ALL), Amcor (AMC), ANZ Bank (ANZ), Aurizon Holdings (AZJ), CSL (CSL), Dexus (DXS), Fortescue Metals (FMG), Goodman Group (GMG), Lend Lease, Mirvac Group (MGR), Oil Search (OSH), Qantas (QAN), South32 (S32), Transurban (TCL) and Westpac (WBC).

The presence of Lend Lease in this group shows ESG at best should be but one of multiple tools used to find the best risk-reward opportunities.

On the negative side, while also carrying an Underperform rating from Macquarie, we find Bendigo & Adelaide Bank (BEN), Insurance Australia Group (IAG), and Woolworths (WOW).

Finally (for now), CLSA analysts recently highlighted that anyone looking to leverage the "it's great to be green" theme that is now emerging on the horizon of the financial sector worldwide, will be hard pressed to ignore Macquarie Group ((MQG)). Apart from having some $4bn invested through its infrastructure asset management business, Macquarie also purchased the Green Investment Bank from the UK government in mid-2017.

Note also: new CEO Shemara Wikramanayake is a commissioner for the Global Center on Adaption, a global climate change initiative, alongside Bill Gates and Ban Ki-Moon.

It is CLSA's view that, "regardless of whether investors believe in climate change, financial markets economics for carbon-emitting industries will be pressured as the economics of renewables improve".

Investors take note, and keep an eye out for that launch later this month.

FNArena offers proprietary tools and impartial analysis for self-managing investors. Our service can be trialed at (VIEW LINK)

FNArena is a supplier of financial, business and economic news, analysis and data services.

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