The Importance Of ESG Analysis

Jun 24 2011 | 8:19am ET

By Michael D. Underhill, CIO, Capital Innovations -- As a veteran of the institutional investment management industry for over two decades, I have seen a series of booms and busts in the market driven by irrational investor behavior, opacity of markets and lack of information.  Managing global timber, infrastructure and agribusiness strategies affords a unique view on the market and reinforces the importance of conducting one’s research into specific issues around company fundamentals and sustainability (i.e., a company‘s capacity to prosper in a hyper-competitive and changing global business environment).

Corporate governance issues have plagued investors particularly with respect to corporate management, transparency, and regulation in emerging markets. Three recent examples of this are Sino-Forest Corporation, China Forestry Holdings, and Cathay Forest Products.

The environmental, social and governance (known as “ESG”) issues around Sino-Forest Corp which led to its current debacle were a confluence of events which included:

  • The lack of clarity in the Chinese log market;
  • Investor concerns over the economic slowdown in China;
  • Wall Street Journal's Heard on the Street column raised concerns about Chinese agriculture and forestry companies;
  • The call to question of the credibility of Sino-Forest Management due to the Muddy Watters report and a lack of response to analysts request for additional information (management cited confidentiality issues);
  • Sino-Forest’s Management in handling of the crisis was unfortunate for investors as company management may have missed a ripe opportunity on the June14th (analyst conference call) to address additional investor issues; And
  • Investors squeezed into a position of “trust” in which they can either “trust” the Muddy Watters report or “trust” company management that displayed inadequate transparency on their corporate governance and reporting structure. 

The ability of Sino-Forest to recover from this crisis of confidence in corporate governance remains to be seen as independent investigative findings are met with skepticism by the investor community.

There is a history of other companies having governance issues as well:

China Forestry Holdings - This Hong Kong listed company (listed since December 2009, but currently suspended) has 11% ownership by the Carlyle Group.  According to the May 5, 2011 Wall Street Journal article “China Forestry Troubles Mount,” China Forestry's former management provided fake bank statements to auditor KPMG, doctored insurance-policies, and falsified logging permits for ~100,000 m3 of wood.  In addition, its former CEO, Li Han Chun, was arrested on charges of embezzlement from the company in February 2011.

Cathay Forest Products - On December 1, 2010 the Company announced that it was not able to timely file its interim financial statements. Management's investigation of its bamboo revenue recognition resulted in the need to restate several prior period financial statements. This TSX listed company suspended trading on January 31st, 2011.

As a signatory of the United Nations Principles of Responsible Investment (UNPRI) and current Chairman of a UNPRI workstream, I was fortunate to be included in a panel discussion at the recent Responsible Investment Conference in New York City earlier this month. Our discussion covered implementation of “sustainability screens” to address ESG issues that arise when making investments for our clients.

During the panel, I addressed a question from the audience on measuring sustainability risk and how a professional money manager might analyze a potential investment on those merits.  The key factors that should be examined are:

  1. A company’s ability to anticipate and manage current and future economic, environmental and social opportunities and risks.
  2. How a company focuses on quality, innovation and productivity to create competitive advantage and long-term value.

As an investment firm, we look to invest in strong, well-managed, successful companies with strong records of delivery on stated strategies and will back our convictions, often taking significant stakes in these businesses. Our average holding period in companies is in excess of two years, with many held for much longer, and engagement with companies is an integral part of our investment management process.  When reviewing the governance of companies, we look for evidence that management is striving to meet the "spirit" of good governance. In this regard, we generally expect companies to comply with the principles and provisions of the UNPRI Corporate Governance Code.

We place great store on both the role and importance of effective corporate governance and sustainable business practices in safeguarding the capital we commit to a business and in the promotion of good practice in these areas.

Michael D. Underhill is the chief investment officer of Capital Innovations, research-intensive asset management firm that focuses on innovative alternative products which he established in 2007. Prior to founding Capital Innovations, he was a vice president of institutional accounts at Alliance Bernstein Institutional where he worked with some of the world’s largest corporate defined benefit plans. Prior to that, he was a vice president of institutional accounts at INVESCO. Before INVESCO, Underhill was with Janus Capital where he built up the nascent institutional fixed income money management capabilities as a complement to their burgeoning mutual fund business in the mid 1990s.

Underhill is a founding member of the Steering Committee for the United Nations Principles for Responsible Investment. The Steering Committee, together with the United Nations Secretariat, bears the ultimate responsibility for the Infrastructure Work Stream, related outputs, and regular reporting to the PRI Advisory Council. He is also the author of the bestselling “The Handbook of Infrastructure Investing” (Wiley 2010) and a faculty member at the CFA Institute where he teaches their infrastructure investing class to existing charter holders.


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