Morgan Stanley's proprietary framework for assessing ESG

Angus Kennedy

Livewire Markets

ESG investing tends to work in the grey in the eyes of investors. It can be deceptive and invites all sorts of questions: Is it simply being used as a buzzword for marketing purposes? What makes something an 'ethical' investment? Is there a trade-off between ethics and performance? 

As a result, it becomes important to develop a process for evaluating such opportunities so you can reliably and consistently compare your options.

This is exactly what Morgan Stanley Investment Management International Equity Team's Head of ESG Research Vladimir Demine and Executive Director Nathan Wong sought to achieve through the development of the Material Risk Indicator (MRI). This proprietary framework allows them to take an objective look at how companies are performing from an ESG standpoint, enabling portfolio managers to understand and quantify future impacts such as the global shift towards decarbonisation.

The MRI methodology offers a concrete way to assess these impacts, and in this wire we unpack how it is applied and the strengths that set it apart. 

Ally Selby from Livewire Markets also recently sat down with Bruno Paulson, a Portfolio Manager from Morgan Stanley Investment Management (MSIM) in this interview, providing a holistic insight into the fund's investment approach to identifying quality compounders.

The importance of ESG factors

For over twenty years MSIM has maintained an unchanged investment philosophy for the global strategies they manage: owning high-quality companies with the potential to successfully compound over the long term. These companies compound by steadily growing while sustaining their high returns on operating capital. Their fund persistently looks to identify material risks or opportunities to this compounding, including environmental, social and governance (ESG) factors.

ESG risks and opportunities are captured through an internally developed ESG scoring framework—the Material Risk Indicator (MRI)—a tool designed to record portfolio managers’ ESG company assessments in a consistent and comparable way over time.

The MRI helps to:

  • Identify material ESG risks and opportunities at the company level
  • Reflect these risks and opportunities in valuation and portfolio construction, if appropriate
  • Identify priority areas for future company engagement

The fundamental question each portfolio manager (PM) must answer is whether the factors in question can significantly impair or enhance the company’s long-term returns on operating capital employed, the primary quality metric. 

Fig. 1 - Proprietary ESG MRI (Material Risk Indicator) Analysis as assessed by the Investment Team

Source: Morgan Stanley Investment Management

PMs are the ones who undertake the MRIs analysis as they best know the companies and industries. While third-party ESG data is used for some of the inputs, this is a supplement to the analysis performed by the PMs.

Clients will benefit from this enhancement as the MRI is designed to improve the capture of risks and opportunities for the companies they invest in. This should further enhance the ability to manage downside risk as well as increase the potential for long-term compounding.

How it works

Each company is assigned a score from A through to E, with A being the highest score attainable. To determine this score, for each company, the relevant PM identifies and records the following:

  • Key ESG risk(s), for example, product safety or data security
  • ESG opportunities, such as technology solutions for decarbonisation or waste reduction
  • Investment implications from these risks or opportunities

In addition, for the company in question, the PM will identify if there is a low, medium or significant level of concern with respect to the following team-agreed universal risks:

  • ­ Greenhouse gas (GHG) emissions
  • ­ Governance (with a particular focus on management incentives)
  • ­ Diversity/culture (board, senior management, staff)
  • ­ Safety (product, broader workforce, environmental)
  • ­ Data security/privacy
  • ­ Tax (transparency, strategy, policy, risk).

They will also document the key industry-specific risk(s) Include quantifiable ESG data, currently comprising:

  • ­ Carbon tax impact on EBIT at $100/t of CO2e
  • ­ Equileap* gender equality score
  • ­ Impact of normalised global tax rates
  • ­ Pay X-ray score (our proprietary assessment of management incentives).

How does the process impact portfolio construction?

The nature of ESG factors can make it challenging to quantify their impact. As such, a range of methods are employed to reflect the outcome of our ESG analysis in the portfolio:

  • Where feasible, they run scenario analyses e.g. forecasting the impact of an ESG factor on the company’s growth rate, profits or CAPEX and the resulting change in fair value — for instance, modelling the impact on profits and valuation of consumer staples companies switching to more sustainable packaging. 
  • The WACC (weighted average cost of capital) may be adjusted to reflect the higher or lower risk.
  • They may reflect potential risks by adjusting the position size, in addition to any model or WACC changes.
  • Finally, the team may choose not to invest in a candidate company if we believe ESG risks as assessed by the MRI are too high. 

It is important to note, however, that a high MRI grade does not automatically suggest a large position and a relatively low MRI grade does not automatically trigger a reduction or divestment of a holding. The ESG assessment is an important component of the research process, not the sole driver of investment decisions.

 The strengths of the MRI approach

  • It is entirely portfolio manager designed and driven.
  • The MRI framework is not reliant on third-party assessments and data— these are simply a resource.
  • Absolute, rather than sector-relative scores are assigned, which helps compare companies across different sectors, reflecting a bottom-up, absolute, benchmark-agnostic mentality.
  • There is a focus on key ESG factors and their impact on the investment argument, rather than ticking every possible (and possibly irrelevant) box.
  • The MRI allows us to compare companies and identify leaders and laggards in specific areas, enhancing targeted engagement.
  • The MRI is structured but not mechanistic—the scores reflect the PMs’ holistic view and are not constructed using a formula.
  • Overall, the process enables team discussion and challenge, with changes tracked over time. 

Conclusion

When the team at MSIM assess stocks and make investment decisions, they debate their key merits and shortcomings as a team. There is a focus on those elements, including ESG factors, that are most impactful on the long-term sustainability of a company’s return on operating capital. The MRI strengthens the approach as it adds further structure, reference and integrity to long-standing investment processes, which is designed to identify reasonably priced, well managed, high-quality compounders with a strong or improving ESG profile, across the globe.

Invest in quality

Morgan Stanley Investment Management is a global franchise delivering innovative investment solutions across public and private markets worldwide. Follow Portfolio Manager Bruno Paulson for more ESG related insights, or give this wire a like to let us know you enjoyed it.


*Equileap is a leading third-party provider of data and insights on gender equality in the workplace.

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