Why Opt for a Transitional Approach to Sustainable Investing?

The number of sustainability-focused funds and their close relatives — climate, ESG and impact funds — has multiplied over the past decade, giving those who are interested in this type of investment opportunity no shortage of options.

Yet many of the challenges investors seek to address by supporting sustainability-minded companies persist. Greenhouse gas emissions continue to increase, as does coal consumption. Deforestation and the use of child labor are on the rise.

We believe sustainability-focused investing can be more effective by deploying a transition-based approach. This view recognizes that opportunities can arise while companies are in earlier stages of transitioning to greater sustainability.

The approach includes companies that are not yet sustainability leaders, providing investors with a wider range of opportunities that can potentially generate attractive returns or help avoid the style tilts often seen in traditional sustainability funds.

In this brief article, we summarize the logic behind transition investing and provide insights into how to find these opportunities.

Transition Investing Often Embraces Value

Traditional sustainability funds tend to invest primarily in companies that have already been recognized for their industry-leading sustainability practices. These are often best-in-class growth companies that trade at higher-than-average valuation multiples. The result: funds with a “sustainability” label may look fairly similar to cap-weighted market indices.

This bias toward investing in sustainability leaders can produce a style tilt, with large growth stocks, often in the tech sector, overrepresented. In contrast, transition investing can embrace companies in traditional industries that often trade at lower valuation multiples, or firms whose sustainability-related value-creation potential has been overlooked.

In our view, transition investing should consider a wide range of firms that recognize this potential for value creation by enhancing their sustainability practices. This may even include industries such as mining, oil and natural gas, where resource depletion, not regeneration, is the norm.

Taking this view may reveal potential opportunities to help generate alpha. It can identify overlooked companies that recognize the potential sustainability offers.

We believe companies become more valuable as they progress toward more sustainable business practices. As companies transition to greater sustainability, they can also have an impact that goes beyond their own operations.

For example, a company in a carbon-intensive industry that embraces cleaner energy sources can inspire its industry peers to do the same. A company that chooses to source raw materials from responsible parties can reduce labor exploitation or deforestation, affecting entire supply chains. Investors can benefit from the value this creates.

Transition Investing Calls for Active Ownership

It takes time and effort to identify companies in earlier phases of transitioning toward sustainability. This is particularly true for businesses in “gray” industries or those that are just beginning to make progress in reducing their carbon footprints.

Instead of replicating a “sustainability leaders” benchmark, we think this active approach can offer greater potential. However, in our view, it requires ongoing monitoring and engagement with companies in transition.

To do so systematically, we believe transition-focused investing should identify metrics and milestones that indicate whether a company is making progress toward greater sustainability. Failure to meet those metrics would indicate a need for discussions with management and the board of directors.

Ultimately, this monitoring and engagement could lead a transition-focused investment strategy to exit a position if momentum stalls for too long, or practices backslide. This approach provides feedback to company management about the importance of continuing to move toward greater sustainability.

Transition Investing Goes Beyond Environmental Concerns

Sustainable investing is often closely or exclusively associated with reducing greenhouse gas emissions, often specifically CO2. We believe this view is too narrow. There are many ways to improve the environment through economically sound sustainable business practices, including reducing plastic waste, water use, deforestation and biodiversity loss.

As we noted above, investing in the transition to a more sustainable global economy encompasses more than environmental issues. For example, does a company pay its employees fairly? Are working conditions safe?

Companies that are improving in these areas can represent potential investment opportunities. According to FTSE Russell, companies that make the list of Fortune 100 Best Companies to Work For^®  outperformed the market by 3.50 times, over a 27-year period.¹

Corporate governance can also contribute to the transition to greater sustainability. Japan is widely recognized for recent improvements in its corporate governance practices, and the Japanese stock market has benefited.

External ESG Ratings Can Miss Transition-Based Opportunities

Where can investors find companies that are transitioning to sustainability? Third-party data aggregators compile and publish sustainability or ESG rankings and scorecards, which are often based on unaudited information from the companies themselves.

Using industry-specific key performance indicators (KPIs) can be a better way to track how businesses are progressing toward greater sustainability. Examples include the percentage of energy use derived from renewable sources, an emphasis on truly recyclable packaging materials, or product offerings that help users reduce their carbon emissions.

KPIs can also help investors avoid companies whose lack of focus on sustainability could hurt profitability. That could include measuring the percentage of revenues an information technology or financial services company devotes to cybersecurity. Inadequate attention to this issue poses risks to society and a company’s profit margin. In many industries, product recalls could indicate a lax attitude toward safety that could harm consumers and the bottom line.

We believe taking an active, analytical approach to transition investing that goes far beyond third-party ESG ratings can identify overlooked opportunities. Companies that fall outside of traditional definitions of “sustainable” or may be in the early stages of embracing sustainable business practices can offer investors opportunities that should not be overlooked.