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Our ESG Journey

We view the increasing importance placed on environmental, social and governance (ESG) factors as one of the most notable investment management trends in recent years. Conversations with our clients, management teams of portfolio holdings and team members have suggested that “how business is conducted” is increasingly important. The business news media certainly took note of this trend in 2019, prompting widespread public discussion of the role of business in society. 

While the consideration of ESG factors has always been an implicit part of our investment process—which is focused on identifying high-quality franchises with sustainable profit-growth drivers—we embarked on a journey at the beginning of 2019 to establish a more structured framework. We spent the first half of the year defining and understanding how we could more formally integrate ESG assessments in a way that complements our existing process.

This journey has led us to a two-stage framework that pairs with our existing research and capital allocation process. For new investment ideas, as we work to vet a company’s franchise strength and profit-cycle catalysts, we are now explicitly identifying key “ESG issues that matter” facing the business. In this stage, we’re seeking to understand key ESG risks and opportunities that could impact future stock returns.

If and when a stock is added as a Garden investment, a new phase of our research begins. As always, we will continue to deepen our understanding of the franchise and profit-cycle dynamics, seeking to build conviction in (or disprove) our investment thesis before becoming a Crop investment by committing significant capital. In parallel, we are now adding layers to our ESG research, with the goal of developing a good sense of whether we’re willing to partner with this company by the time a stock is ready to become a Crop investment (we’re calling this stage our “stewardship check”).

In addition to this more formal ESG research (which we view as quite complementary to our existing process), we are beginning to selectively engage with portfolio holdings on ESG issues. While we plan to learn and evolve in this area, we suspect our perspectives on topics such as executive compensation, corporate governance, social responsibility and environmental impact will help companies improve their performance in these areas over time, which we expect can contribute positively to share-price performance.

ESG is broad and complex, and we are taking an open-minded, humble approach to our efforts. In addition to this being the right thing to do (in our opinion), we believe there is potential to enhance our assessment of investment risk and reward. For example, our work this year on climate change has already made us better appreciate the profit-cycle opportunities for companies that may stand to benefit from global efforts to reduce emissions or manage the impact of those emissions. We also see increasing evidence that stock valuations are being influenced by investors’ perceptions of whether a business is on the good or bad side of ESG issues. And as we reflect on our team’s first 25 years of stock-picking, we look back on some of our least successful investments and suspect that more rigorous considerations of ESG factors could have helped us avoid some painful mistakes.

Our capital allocation process is designed to build position size according to our conviction. Portfolio holdings develop through three stages: Garden℠ Crop℠ and Harvest℠. Garden℠ investments are situations where we believe we are right, but there is not clear evidence that the profit cycle has taken hold, so positions are small. Crop℠ investments are holdings where we have gained conviction in the company’s profit cycle, so positions are larger. Harvest℠ investments are holdings that have exceeded our estimate of intrinsic value or holdings where there is a deceleration in the company’s profit cycle. Harvest℠ investments are generally being reduced or sold from the portfolios.