Investing: Importance of investing in the ESG transition

This article first appeared in Wealth, The Edge Malaysia Weekly, on June 28, 2021 - July 04, 2021.

"If the management is going to execute accordingly to improve their ESG criteria, then the market will recognise that. We think their ESG ratings will improve and that’s where you can see the returns.” - Anand

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Malaysian investors and companies that do not take heed of ESG (environmental, social and governance) factors are at risk. Already, bans on rubber glove and palm oil exports from Malaysia, owing to allegations of forced labour, have affected the performance of local companies recently.

This is a reflection of the growing importance placed by global investors on ESG. At this time, Malaysian investors should also incorporate ESG into their strategies, observes Anand Pathmakanthan, regional head of equity research at Maybank Kim Eng (MKE). 

“When companies are more aware of ESG issues, it tends to give investors greater confidence that their strategies, in terms of what they’re pursuing for growth in a sustainable manner, are more holistically considered and justifies the risk premium on a stock,” says Anand, whose team published a Malaysia ESG compendium titled “Sustainability: no longer optional” in April. 

The 128-page compendium takes a comprehensive look at ESG mega trends and reveals MKE’s maiden ESG portfolio. It also has tear sheets highlighting the ESG performance of companies in 15 sectors in Malaysia. 

If Malaysian companies and investors do not take ESG factors into consideration, they are ignoring the risks that will come as countries transition into a net-zero carbon emission economy. China has pledged to reach that target by 2060 and the US by 2050.

Foreign investors may also lose interest in local companies that do not meet ESG criteria. Anand brings up the power generation sector as an example. Tenaga Nasional Bhd draws more than 60% of its power in Peninsular Malaysia from coal plants. 

“Tenaga has always been a benchmark for foreign investors because it’s a big and decent stock, but foreign stockholding has fallen to a decade low, making it one of the cheapest utilities in Asia. Why? We can only surmise that it is ESG concerns. If a fund manager holds on to Tenaga, they have to answer a lot of questions from investors as to why they are investing in a huge polluter and emitter of carbon,” he says.

In 2016, foreign shareholders owned 29% of the company whereas, today, the number is 12.4% (as at end-March), according to the compendium. 

Anand highlights another example: the palm oil industry. Companies such as General Mills, Nestlé and Unilever have suspended FGV Holdings Bhd from their supply chain, owing to alleged exploitative labour practices in the company. 

“Everyone always asks, why are plantation stocks not performing in line with crude palm oil (CPO) prices? It could be that people don’t think CPO prices are sustainable, but that explains only part of the divergence because the difference is huge. If you look at the foreign shareholding of plantation stocks, you’ll see that European funds have been selling out of this sector for years now because they don’t like the environmental profile of these stocks,” he says.

As Malaysia’s major trading partners such as China, the US and Japan are heading towards their net-zero carbon emissions goals in the next few decades, Malaysian companies could risk being locked out of markets and supply chains if they do not match the pace of transition. 

But it is not just about managing coming risks. There are opportunities that Malaysian companies can capture in the transition, observes Anand. Renewable energy and electric vehicles (EVs) are some prime examples.

“Some of the better-performing stocks in the past year through the pandemic have been ESG plays, such as Solarvest and Cypark, which have a renewable energy portfolio. There is the tech space as well. These stocks are akin to what we call the new economy stocks that can thrive in a low-carbon world,” he says. 

Unfortunately, Malaysia is lagging behind Asean in the initiatives to develop EVs and the relevant infrastructure, a point that is elaborated in detail in the compendium. 

“The opportunities are there, but I must say that Malaysia is not at the forefront of investors’ minds when they think of these opportunities currently,” says Anand.

That is because Bursa Malaysia comprises mainly sustainability-challenged sectors such as financials, oil and gas (O&G), power utilities and plantations, he adds. These sectors, alongside foreign-labour dependent exporters such as the rubber gloves sector, often attract negative ESG headlines. 

What’s in the MKE ESG portfolio?

The MKE Malaysian equity research team published ESG tear sheets for 61 local companies with market capitalisation above US$1 billion. The team then ranked these stocks from those that had the best ESG scores to the worst. 

After this information was combined with financial analysis, the team generated an ESG portfolio with 12 “buy”-rated stocks and four “hold”-rated stocks. 

The portfolio was introduced as MKE’s first step into understanding ESG issues, as the bank plans to eventually integrate it into its research and valuation analysis across Asean in various stages.

The quantitative ESG input is drawn from Sustainalytics, a global ESG data provider.  

This information is featured in MKE’s ESG tear sheets, which also include assessments on controversies that the companies are involved in and momentum. The latter refers to the interest the company shows in improving its ESG scores.

All these factors are considered before MKE issues a “buy” or “hold” call on the stocks. That means a stock with good ESG rating alone may not necessarily be included in MKE’s ESG portfolio. 

For instance, the property sector generally has favourable ESG scores, but it does not feature heavily in the ESG portfolio, owing to operating challenges such as oversupply, high gearing ratio and affordability concerns. 

“Another example is Genting Bhd, which is rated fairly well by Sustainalytics. But there have been many related-party transactions throughout the history of the group that are perceived to have favoured the controlling shareholder over minorities, so we didn’t consider the stock to be an ESG pick,” says Anand.

The analysts’ views always prevail, he emphasises, because they can provide forward-looking views on the stocks and have a personal understanding of the companies, having covered them for years. This is also why O&G companies such as Yinson Holdings Bhd and plantation companies such as IOI Corp Bhd are in the ESG portfolio. 

“If we use just Sustainalytics, it will screen them out. But we know the management well and we are in deep discussions with them on their plans for pivoting their business models. We have a lot of faith that they will execute on these plans,” says Anand.

Including sectors such as O&G into an ESG portfolio may seem counterintuitive to some. But Anand believes investing in companies that are transitioning to become sustainable can generate the biggest alpha for ESG investors.

He points to an MSCI research from 2017 that studied how changes in ESG scores move equity prices. The analysis showed that a change in a company’s ESG profile had an impact on valuation levels and stock prices that was not explained by the general market or other factors. ESG score upgrades led to higher valuations and vice versa.

“We have great ESG-rated stocks in our portfolio. But we should also have other stocks where the analysts believe the management understands what is required of them in the new economy and sustainability megatrend. If the management is going to execute accordingly to improve their ESG criteria, then the market will recognise that. We think their ESG ratings will improve and that’s where you can see the returns,” says Anand.