WHAT IS ESG, STEWARDSHIP & WHY DO WE DO IT?
ESG refers to a set of factors (Environmental, Social and Governance) that impact the ability of companies to generate sustainable returns over the long term. Investing through the ESG lens involves understanding the governance structures and culture of a company, employing a broad view of changes taking place in the world and assessing the effect these can have on a company’s cash flows, balance sheet, reputation and, ultimately, corporate value.
As stewards of our clients’ capital, we take a holistic view of our investee companies, looking at all material information, whether quantitative or qualitative. There is compelling evidence that ESG factors influence returns over the long term, and therefore it must be incorporated by fiduciaries when assessing risks and opportunities.
As active investors, we take the position that true stewardship entails going beyond passively investing and requires us to take an active approach to steering our investee companies towards creating superior ESG outcomes. The recent COVID-19 crisis and fall in dividend payouts is an example of how an active approach to ESG through true stewardship can create tangible differences to our client’s investment returns.
“As active investors, we take the position that true stewardship entails going beyond passively investing and requires us to take an active approach to steering our investee companies towards creating superior ESG outcomes.”
HOW DO WE DO IT?
As bottom-up investors, our process starts at the company level. Once an investment prospect has been identified, we subject it to rigorous fundamental analysis and peer review to decide whether it merits inclusion in our high-conviction portfolios. ESG analysis is embedded in this assessment, influencing key assumptions such as the cost of capital, revenues, or costs and thus our estimate of a company’s intrinsic value.
In broad terms, we divide our process into three categories: identification, integration and active ownership. Responsibility for this work lies with the portfolio managers and analysts – the people who know the companies best. In this way, we can achieve true ESG integration.
ACTIVE OWNERSHIP, GOVERNANCE AND DIVIDENDS
The G in ESG stands for governance. In our income portfolios, we place a particular emphasis on governance, which stems from the belief that this is a fundamental determinant of long-term performance. Governance issues are often reflected in a company’s environmental and social track record, making it a reliable proxy for wider sustainability.
One aspect of governance is ensuring that a company is disciplined in its allocation of its capital. Capital can be used in a variety of ways, but broadly speaking, it is being used in one of four ways at any given time:
1. Capital is tied up in the business as working capital for the day-to-day operations of the company.
2. Capital is being invested in assets that will produce a growing stream of earnings for the future.
3. Capital is sitting in the companies accounts as cash waiting for an investment opportunity or a rainy day.
4. Capital is being returned to shareholders in the form of dividends or share buybacks.
For mature businesses, dividends are an important source of shareholder returns. And while boards and company management usually do the right thing, there are cases when companies retain capital that could and should have been paid to shareholders. Sometimes this is done so that managers can expand the scope of their corporate domain. At other times, it is retained under the auspices of conservatism by management who feel they require extraordinary financial cushioning upon which to run the business.
We view a company’s commitment to regular dividends as an important source of capital discipline and thereby a critical element of a company’s governance profile. For us, these dividends represent a commitment to shareholder return. In the same way that individuals demonstrate a commitment to funding their retirement by saving a portion of their wages each year, a mature company demonstrates its commitment to shareholder return by paying a regular stream of meaningful dividends. Thus, when an investee company with a history of dividend payments cuts or significantly reduces its dividend, we do not take it at face value that this is the correct decision.
As stewards of our client’s capital, we have a duty to probe the reasoning behind dividend cuts, and ultimately, to resort to activism if we find the decision is not merited by the underlying business case. The recent COVID-19 pandemic provides a particularly compelling example of the value generated by our active approach.
“For us, these dividends represent a commitment to shareholder return. In the same way that individuals demonstrate a commitment to funding their retirement by saving a portion of their wages each year, a mature company demonstrates its commitment to shareholder return by paying a regular stream of meaningful dividends.”
COVID-19 & DIVIDEND OUTLOOK & ACTIVISM
“For the investee companies in our Income portfolios, our message is clear – if a company has reasonable cashflow and a sound financial position, dividends should be paid.”
The economic lockdown in response to the COVID-19 pandemic has created a uniquely challenging environment for many traditionally robust businesses. This difficulty is being reflected in the near-term outlook for dividend payments for the wider share market. For example, as of 31 August, based on broker consensus estimated for next 12 months dividends, the dollar dividend stream for the Martin Currie Equity Income strategy has been revised down by approximately ~25% since the start of February (pre-COVID-19) estimates1. For the broader market (i.e. S&P/ASX 200), it is down almost ~40%. But while it must be acknowledged that there are many companies reckoning with real existential and solvency issues related to these economic conditions, not all companies are facing the dire outlook that the financial media might have you believe.
As such, we were very concerned to hear that many of the high-quality ASX-listed companies that we invest in for our clients were equivocating about whether to pay dividends. Given the important role that dividends play during times of crisis, and the robust cash-flow profiles of many of these high-quality companies, we felt that it was necessary to take an activist approach to the dividend question and sent the following (abbreviated) letter to all the investee companies in our income-oriented strategies:
In such difficult economic times, and with an uncertain market outlook, the benefits of both dollar income and franking credits to retirees cannot be underestimated. Retirees are key beneficiaries of these dividends, and they have worked hard to have sufficient capital to fund their own retirement. Charities and Foundations, similar to retirees, also depend on dollar income to fund their own outgoings, most of which benefits society in the form of hospitals, scholarships and other charitable causes.
For the investee companies in our Income portfolios, our message is clear – if a company has reasonable cashflow and a sound financial position, dividends should be paid.
The lack of alternatives to equities for these investors who need a high dollar income stream, and the consequences for the whole economy and future generations should all retirees be forced to be on the Age Pension in the future are stark.
The need for companies to pay out their dividends has never been greater.
THE MARKET RESPONSE
What was the outcome of this activism? I am pleased to report that we've received remarkably positive responses from our investee companies. In many cases, the chair of the company has taken the time to write a detailed reply rather than just an acknowledgement. One chair of a large company said he had been writing about the importance of dividends since the 1990s. He noted that companies receive up to 20% of their dividends back in reinvestment plans, and if they're worried about cashflow, dividend reinvestment can be underwritten for a small fee.
Another company, a large utility, attached our letter to the board papers. They've just announced that because they have a high free cashflow, they will pay special dividends next year. They were pleased with the letter and said it was very timely.
Contrary to what you might expect, this positive response to our active ownership approach is actually the norm. When it comes to ESG and specifically governance, companies most often want to do the right thing for their shareholders and stakeholders but may hesitate when given little or no clear guidance from their board or the broader market. Like a good coach or mentor, we find that our active approach to ownership provides management with the confidence to act with conviction through the knowledge that they are governing in alignment with their most important stakeholders.
Will Baylis is the Portfolio Manager for the Legg Mason Martin Currie Equity Income Fund. Martin Currie’s Income strategies can be accessed in listed format on the ASX through the:
1 Source: Martin Currie as of 31/08/2020, Next 12 Months (NTM) Income yield is calculated using the weighted average of broker consensus forecasts of each portfolio holding –because of this, the returns quoted are estimated figures and are therefore not guaranteed. Assumes zero percent tax rate and full franking benefits realised in tax return for Martin Currie Equity Income.
Past performance is not a reliable indicator of future results. Any returns forecasts are inherently uncertain, and no return is guaranteed. Legg Mason Asset Management Australia Limited (ABN 76 004 835 849 AFSL 240827) is a part of Franklin Resources, Inc.
Legg Mason Australia is the responsible entity of the Legg Mason Martin Currie Equity Income Fund (ARSN 150 751 821and Martin Currie Australia, a division of Legg Mason Australia, is the fund manager. Before making an investment decision you should read the relevant Product Disclosure Statement (PDS) carefully and you need to consider, with or without the assistance of a financial adviser, whether such an investment is appropriate considering your particular investment needs, objectives and financial circumstances. The PDS is available and can be obtained by contacting Legg Mason. The information provided should not be considered a recommendation to purchase or sell any particular security.