Impact investing and the Sustainable Development Goals (SDGs) have gained more prominence in the investment industry. Both appeal to investors who are not only sustainability-minded but also performance-driven: they recognise that positive social and environmental outcomes and long-term investment rewards are compatible.
Hermes has advocated this way of thinking for many years, seeking outcomes beyond performance in our investment and engagement activities. In 2018 we launched an ambitious portfolio: Hermes SDG Engagement Equity. It targets long-term outperformance by investing in small- and mid-cap companies that can – through engagement – contribute meaningfully to the SDGs.
As Hermes SDG Engagement Equity marks one year, Hamish Galpin, Lead Manager and Will Pomroy, Lead Engager, reflect on the progress made and the prospects for 2019.
When you started out, what were your objectives for 2018?
Galpin: The objectives were twofold: to establish a portfolio capable of outperforming in the long term; and from an engagement perspective, to start some of these programmes and establish proof of concept.
What progress have you made in achieving these objectives?
Galpin: I wanted to achieve sufficient diversification, which is a pillar of my investment process. We have achieved that because the proportion of the return generated by stock selection is reasonably high: about 80% of our risk is coming from stock selection.
Pomroy: We had two beliefs at the beginning: one, that smaller companies are perhaps less advanced in their thinking on sustainability matters and also less engaged with shareholders, NGOs and the broader stakeholder community. And two, that the greatest impacts might come from engagements with US companies that have global footprints. Reassuringly, 12 months on, both of those beliefs have been borne out. The smaller companies, especially in the US, have really engaged with us in a much more constructive fashion than we had expected.
Is this positive momentum something you’ve observed across the portfolio or is it confined to a select number of companies?
Pomroy: It is fair to say we have seen it across the entire portfolio – but some companies have made rapid progress and others will require more time and effort to get the management team on board.
Galpin: Some companies have engagement programmes that will take five-to-seven years to come to fruition, whereas others have already started sustainability initiatives that we are helping to guide.
Do you feel like you have a sufficient foundation for progress on engagements across the portfolio?
Pomroy: Yes, we have approximately 50 companies in the portfolio and in this first year we’ve engaged with nearly all of them, with just one or two outstanding and we intend to get a dialogue up and running with them imminently. We will then be on course to have had about 200 individual interactions with those 50 companies, so that’s a lot of activity.
This speaks to the need to have a relatively concentrated portfolio to implement our approach, because it is a resource-intensive one. We are trying to speak to these companies about issues pertinent to them and the communities and environments in which they are operating. That requires us to spend time getting to know the companies so we can have constructive discussions with their management teams and get them to buy in to what we’re trying to deliver.
In 2018, we had 200 engagement interactions with the 50 companies in our portfolio
How important is it to tailor your engagement approach on a case-by-case basis for each company?
Pomroy: The experience borne out by Hermes’ 20 years of engagement reinforces that it is not necessarily the size of the shareholding you have in a company that is key to whether you can deliver on an engagement objective – it is speaking to the right people about the right issues at the right point in time.
Also, we manage a global portfolio, which means we are speaking to companies in very different jurisdictions with very different cultural sensitivities, so we have to make sure the right people are having that conversation. For example, in Japan we have Japanese nationals engaging by using the national language. Key to achieving the engagement objective is building a relationship of trust between us and the company. Mutual trust allows us to enter into in-depth and substantive conversations, which means we can more quickly progress to talking about the action points we want to pursue.
The success of an engagement objective depends on whether you are speaking to the right people about the right issues at the right time
What are some of the positive engagement stories that have emerged from 2018?
Pomroy: We have been speaking to the management team of a concessions caterer about the company’s intake of people from typically under-employed constituencies. They’ve got some very good initiatives in Singapore, Phoenix and London. It’s good that they have these small, local initiatives but, given their global footprint, there’s a lot more they can do. For this to happen, the board needs to take ownership and set group-level targets to require all of the regional operations to adopt what is a clearly emerging best practice throughout the company.
Galpin: One of the key concepts of impact investing is additionality – what we as investors and as stakeholders bring to the table. We can convey a lot of best practices to businesses around the world to portfolio companies. So we can highlight the leading sustainability practices of a European manufacturer to a US counterpart. Companies have welcomed examples of best practices that we have shown them in their respective industries.
What surprises did you encounter this year in running the new strategy?
Galpin: For me there have been two big surprise. One is just how willing management teams are to listen to what we have to say. Sustainability is something that management teams have gone from thinking they ought to consider to something they need to consider. It has now moved from a regulatory matter with the legal department to a boardroom agenda item.
The second surprise has been that, to engage companies in some industries, we have to engage up and down the industry supply chain. Engagement is not simply about engaging one company on its particular activities
It is not about engaging companies about their activities: we have to engage up and down the supply chain
What were the three key lessons of the 2018 for you?
Galpin: The first lesson is that our concept has been validated: we know we can achieve our goals by investing in stocks with a view to engaging on these companies and generating impacts down the line. The second is that we have a timely strategy – the boards are having to work out what to do about sustainability and generally increase their activity in this area, and we can be part of that process as responsible shareholders. The final lesson is that it is going to take five-to-10 years for some of these long-term engagement initiatives to be completed. Even if we can’t really factor in some of these impacts, particularly into the shorter term aspects of our valuation models, we are confident that we will end up with a portfolio of better businesses in five to 10 years’ time. Whether that comes through improved earnings or a stronger stock price, shareholder value will be created as a result and SDG-aligned impacts will have hopefully been created, too.
What is your broad engagement agenda for 2019?
Pomroy: If 2018 was about building trust between ourselves and the management teams, executives and directors of portfolio companies, our focus in 2019 will be on starting to deliver some substantive outcomes. We think we have got management teams on board in a large number of those portfolio companies, so next year we hope to actually start to set out KPIs and get them to commit to specific actions. Many of the engagements that will progress through 2019 will continue through 2020 and 2021, but nonetheless we hope there will be a number of tangible deliverables that we’ll be able to report to our investors throughout 2019 which will bring this approach to life.
Do you anticipate any impacts will materialise from current engagements in the coming year?
Pomroy: Without wanting to be a hostage to fortune, I am confident that in 2019 we will have some compelling stories to tell. As we go through the first reporting season for companies we are engaging with, we should start to see more information-rich reporting disclosures. The companies we hold will begin to map their activities across their supply chains, direct operations and products and service to the SDGs and consider what more they can do. That will be the first step for many of them.
We should also see tangible impacts from a South African resources company that we invest in. There are high rates of HIV in rural parts of South Africa – and higher rates still among working-age male populations in and around mining operations in the country – so we are targeting the people that this company is concerned about. We have introduced it to a US pharmaceutical business whose community outreach capabilities can raise awareness of HIV prevalence and encourage testing. This should ideally reduce the incidence rates of HIV within the workforce and wider community.
Healthier workers and families should result in better productivity and profits for the company and hopefully better returns for shareholders. This reinforces the point that our portfolio seeks a dual benefit at all times – not just doing good for the sake of doing good, but because doing good ultimately leads to better outcomes for businesses and their investors, including our clients.