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What do you aim to achieve in your engagement conversations? Are companies responsive to your engagement? These are just a couple of the most commonly asked questions about our SDG Engagement Equity capability by our clients and prospective investors.
In our latest edition, we sat down with our SDG Engagement Equity team to tackle the most pressing questions about the Fund.
We focus on investing in attractive companies with the potential – through engagement aligned with the UN SDGs – to generate outcomes that benefit people, the planet and investors.
Amid growing evidence that a company’s long-term success is correlated with the health of the economies, communities and environments in which it operates, our team is committed to delivering attractive returns whilst also engaging for positive societal and environmental impact.
By engaging with companies on specific, relevant SDGs, we gain valuable insight into investment risks and longer-term opportunities that the company is exposed to. Such insight includes how a firm manages scarce resources, how it invests in its people, and how it supports equitable economic growth.
The 17 SDGs provide a common reference point for us to identify, assess and measure a company’s impact on society and the environment. Companies that can build and deliver innovation to help the world meet these goals are poised to benefit significantly as structural shifts in policy, technology and sentiment, create a fertile backdrop for them to capitalise on.
Our research has found that approximately 40% of the SDGs 169 targets are relevant points of dialogue between investors and corporations.[footnote]Source: Federated Hermes, as at 2020.[/footnote] Indeed, every company is affected by, or can contribute to, one or more of these goals – and, by so doing, they will almost always improve their overall business prospects.
As investors, we have the opportunity to influence what companies do and how they do it.
We will only invest in companies in which we see the potential for engagement to help the company create positive impact towards one or more of the SDGs. In assessing opportunities, we look at a company’s entire supply chain, including its relationships with and influence over its supply partners. We consider the company’s direct operations, including its resource efficiency and its approach to its workforce. We also examine its products and services – do they have the potential to reach under-served markets or to develop product offerings supportive of a more circular economy?
Through our engagement, we hope to encourage new initiatives, create new relationships, accelerate progress and raise ambitions, with a view to improving both the business’ long-term success and its contribution to SDG attainment.
While we shall cajole where necessary, we want to give management the confidence to be bold and ambitious by supporting companies in implementing new approaches. We execute a customised engagement plan for each portfolio company, which consists of general and specific objectives. The topics we engage on with every company include eliminating discrimination among employees and fair pay (which address the gender equality, no poverty and reduced inequalities SDGs).
However, for example, in an engagement with a food retailer, we would also challenge it on a range of company-specific practices, such as the nutritional value and prices of the goods it sells, and the sustainability of the producers in its supply chain (which relate to the SDGs of good health and well-being, responsible production and consumption, life below water and life on land).
Our engagement is integrated into the investment process, and is informed by a real understanding of the business and realistic expectations. For this reason, we have found high levels of engagement from the majority of the companies we work with.
When identifying companies for inclusion in the fund, we consider how ‘engageable’ a company is as well as its scope for making an improved contribution towards the goals. Successful engagement must include the following three characteristics in order to be both meaningful and impactful:
Our understanding of effective shareholder engagement has been developed over many years. In our experience, dialogue with board members and senior executives is more effective than blunt coercion. What matters most is the strength of our argument, not the size of our proxy vote (although, sometimes, that can help).
We invest in, and engage with, high-quality small- and mid-cap stocks globally because this is where we think the greatest opportunity for influence lies. These companies are typically less well known than blue-chip names, and many have not previously been engaged by active shareholders. As a result, we believe that they have the potential to go on a more profound sustainability journey and, therefore, drive greater positive change. Their smaller size also enables us to directly access their management teams and boards, improving our ability to work constructively.
In principle, all companies are engageable to some extent; they all have employees, operations and some form of supply chain that could be more efficient.
However, we only seek to invest in those companies that have clear potential to make a positive contribution to the SDGs, and whom we believe are open to engaging on the matter. We start this process of identifying quality businesses with a high return on equity and high returns stability. Not only are these quality characteristics important from an investment standpoint but, in our experience, a strong balance sheet and stable returns means a company is more likely to have the bandwidth to invest in and manage new sustainable initiatives.
To assess how receptive a company will be to engagement, we consider management quality and governance, and speak with management prior to investing. In general, we have found that companies with better governance structures are more open to engagement.
When assessing an opportunity for engagement we look for a diverse range of characteristics, such as:
As figure 1 shows, we have engaged on all 17 SDGs. However, we focus our engagement on the SDGs towards which companies can make the most tangible and direct contributions.
Figure 1. SDG engagement: relative to share of activity
Source: Federated Hermes, as at 31 December 2020.
The provision of employment is among the most direct ways that companies impact individuals and society. Through the provision of decent employment with stability, safe environments, training, and fair pay and benefits companies directly influence our economic, physical and mental wellbeing and in so doing can address issues around gender, economic and health inequalities. At the same time, companies commonly assert that employees are their most valuable asset. A company’s approach to working practices and employee benefits are a critical component in recruiting, retaining and motivating its people, and by doing so it maximises the productivity and value of this most important asset. For investors, employee job satisfaction and engagement offers important clues to the health and future performance of a company. More recently, we have increased our focus on SDG 5 – gender equality – among others, which corresponds to our enhanced emphasis on the topic among our holdings in Japanese companies, in particular, during 2020.
We use our proprietary milestone system, shown below (developed by EOS at Federated Hermes (‘EOS’)), to track our progress towards each engagement objective.All company engagements are logged according to the issue being addressed, the corresponding SDG and the objective we are working towards. While all of our interaction is mapped according to the same broad framework, the concerns and related objectives of each engagement vary according to the company and its circumstances.Our engagement framework
While we set SMART engagement objectives and have recordable milestones along the way, measuring engagement is, in our experience, an art rather than a science. For this reason, we have developed meaningful governance processes.As a team – and in conjunction with colleagues from across EOS, and other investment teams – we formally review each engagement case and its progress every six months.This review informs our engagement priorities with the company and helps us to decide the position weighting in the portfolio. It also ensures that we remain focused on the fund’s dual objectives of delivering investment returns, and social and environmental impact.
We are committed to reporting on the progress and outcomes of our engagement efforts at both stock level and aggregated portfolio level.
At portfolio level we are focused on measuring how our engagement enhances a company’s contribution to the SDGs. At present, we report on how our engagement aligns with the SDGs and the changes that have occurred on a number of proxy measures for sustainability performance over three years. These measures include:
As disclosure from held and benchmark companies continues to increase, we hope to build on our reportable metrics and are currently expanding the scope of our fund-level measurement and reporting.
On an individual company basis, we first outline our theory of change and use narrative to show how our corporate engagement is generating real change within companies. We then explore the impact these changes are having on the ground in communities and the environment.
The fund aims to improve a company’s contribution towards the SDGs through engagement rather than seeking to buy companies that are already aligned with one or more of the goals.
We note that reporting on SDG alignment currently appears to be very subjective and particularly sparse within many global mid-sized companies. Furthermore, most analytics tools focus solely on a company’s products and services, and often fail to take account of impacts – negative or positive – generated upstream or within a company’s direct operations.
Finally, we recognise that impact is often location-specific and therefore difficult to aggregate. As a result, we do not compute alignment of individual companies in the portfolio with the SDGs.
We are instead focused on measuring how our engagement has changed the way a company is contributing to the SDGs. Ahead of investing in a company we will analyse the opportunities for engagement towards the SDGs. As a result, we focus our reporting on tracking engagements and their progress through completion; also, where possible, monitoring and reporting improvements on relevant metrics aligned to those objective (e.g. carbon emissions, waste production).
All holdings should provide engagement opportunity and investment upside potential. The natural time to sell a stock will be the point at which a stock is fully valued, and the engagement programme has reached maturity, i.e. when the engagement targets set have been met and reflected fully in the share price.
A company may be held if the stock price, at the time of review, does not reflect the underlying value of the business and where selling the position would deprive investors of relatively low risk upside over a short- to medium-term horizon. Equally a fully valued stock may continue to be held if it still has strong investment merits and unfulfilled engagement potential. Sizing in these instances would be adjusted accordingly.
Investments are reviewed on a six-monthly basis, with a stricter view taken after 18 months to assess progress towards the engagement target. If the engagement plan is not being fulfilled, or is unlikely to progress further, a sell process will be initiated. A stock should, in principle, be sold if:
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