Why ESG considerations matter and how they are embedded in The Mercantile's stock selection process

Environment, Social and Governance (ESG) considerations cover a range of issues
related to a company’s behaviour with respect to the environment and society, including
its employment and health and safety practices – Guy Anderson, Portfolio Manager

The governance aspect refers to the policies companies adopt within their own organisations, to protect shareholders’ interests, meet regulatory obligations and respect the communities in which they operate.

The term ESG also encompasses the concept of sustainability – the long-term implications of a company’s behaviour in all these areas. This is an essential question for long-term investors such as Mercantile, as the drivers of a company’s valuation – its earnings prospects, competitive position and strategy – must be durable over time.

For example, companies with positive ESG characteristics may provide attractive investment opportunities because environmentally-friendly production processes, happy staff, satisfied customers and a culture of transparency should allow businesses to thrive and maximise their potential – and investor returns – over the long term. Weir Group, which provides specialised mining machinery, is one of The Mercantile’s holdings benefiting from being at the forefront of efforts to reduce carbon emissions.

Its equipment is used to process most of the world’s copper, an essential component in electric vehicles, charging infrastructure and many other ‘clean energy’ products. Weir is experiencing strong demand accordingly.

Softcat, a reseller of IT hardware and software, and one of The Mercantile’s largest positions, illustrates the power of good governance. Softcat attributes its impressive long-term growth and increasing market share to its strong corporate culture and the performance incentives it offers staff.

Conversely, companies with poor ESG credentials are likely to underperform over the long term. High carbon emissions, unethical supply chains, or products such as cigarettes and gambling facilities that produce negative social outcomes, will attract scrutiny from regulators, the media and consumers that may eventually undermine shareholder value.

Mounting awareness of the urgent need to address climate change and other ESG issues is increasing investor focus on these matters, to the extent that ESG considerations have become a key determinant of valuations and investment returns. It is thus imperative that they are fully integrated into investors’ stock selection processes.

In addition to their role as major drivers of a company’s financial performance, ESG factors also have broader implications for society as a whole, and The Mercantile’s managers believe they have a fiduciary duty as responsible investors to ensure that the trust’s investments are run in a sustainable way, for the good of all stakeholders.

As an illustration of J.P.Morgan Asset Management’s (JPMAM’s) commitment to this objective, the company is a signatory to the United Nation’s Principles of Responsible Investment.

Mercantile has been at the vanguard of efforts to incorporate explicit ESG factors into its fundamental stock analysis. As a first step in this process, JPMAM’s Sustainable Investing team compile data on easily available metrics such as a company’s water usage, its carbon emissions and the diversity of its staff and board.

This allows companies to be compared on a like-for-like basis.

Analysts also complete an ESG questionnaire on each potential investment, to identify risks and opportunities that aren’t captured in the raw data.

This analysis forms the basis for the most important part of The Mercantile’s approach to ESG issues – engagement with the management teams of all the trust’s existing and prospective investments.

Given The Mercantile’s long term focus, in many cases these two-way dialogues have been ongoing, at regular intervals, for years, allowing both parties to build trust and understanding.

ESG factors are one of many topics covered in these conversations, but they provide a forum for the trust’s managers to convey concerns and suggestions regarding a company’s ESG credentials, and to encourage best practice in all areas.

These interactions can have a meaningful, positive impact on a company’s behaviour, its commercial and financial performance, and thus, ultimately, on shareholder returns.

Rigorous analysis and regular engagement with the management teams of The Mercantile’s portfolio holdings are highly effective in identifying potential ESG risks, but still, there are inevitably instances where such risks escalate unexpectedly.

In such cases, The Mercantile’s managers respond quickly, engaging with the company to understand the nature of the risk and its plans to address the issue.

For example, they have challenged retailers on the ethics of their supply chain practices, engaged with house builders on fire safety standards and questioned the executive pay proposals of many companies.

For The Mercantile’s managers, integrating ESG factors1 into their stock selection process and engaging with companies on these issues delivers many benefits, and is, from all perspectives, simply the right thing to do.

For shareholders, this is manifested in the trust’s superior long-term returns, while at the same time encouraging responsible, sustainable and improved outcomes for other stakeholders including the environment, employees and society as a whole.

Find out more about The Mercantile Investment Trust >

Watch: Guy Anderson's latest video update

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