The E, the S and the G of competitive advantage
ESG leadership can improve (or hinder) a company's competitive positioning relative to other industry players. Velox's strategy of ESG integration is driven by our strong belief that ESG factors are vital in assessing the quality of a company and its long-term prospects. Ignoring ESG risks and opportunities in one's analysis can be as detrimental as, for example, failing to take into account the quality of a company's product or its financial position.
Well-publicised ESG risk events can materially impact performance. Examples could be environmental accidents, labour disputes & supply chain controversies, such as reports of Boohoo Leicester suppliers’ working conditions. In today's world, however, the interplay of ESG factors and stock's performance can work in more complex and nuanced ways.
So how can ESG leadership widen a company's moat? When management recognizes the importance of adapting to evolving environmental, social and governance conditions, they are better able to capitalise on strategic opportunities and face competitive challenges. One example of a company that has been highly successful at solving their clients' environmental challenges is the Swiss specialty chemicals company Sika. This well-run earnings compounder has been a long-standing research favourite at Velox due to its strong leadership position, high organic growth with strong margins, and solid M&A track record. In addition to that, management has positioned the company extremely well to address environmental issues within the construction industry. With 40% of global CO2 emissions coming from the construction market, addressing the environmental impact is a huge pain point for Sika's clients. 70% of Sika products have a positive sustainability impact, such as: additives that reduce CO2 consumption in cement by 20%; or technology to reduce water content in concrete by 40%. As a result, Sika has outgrown its peers by ~10pp over the last 3 years.
Changing consumer focus is driving corporate actions and has the potential to create entirely new business models. H&M was the first retailer to use Circulose , a pulp made from 100% recycled textiles. Circulose[i] is produced by a Swedish company Renewcell that the Velox team has been following since IPO. Circulose has a strong competitive advantage as it is plug & play from fibre producer perspective (no need to change machinery or processes). This technology could finally be the answer to closing the loop in fashion.
Customers are often willing to pay extra for "green" products. Indeed, McKinsey research [ii] showed that 70% of consumers surveyed across multiple industries in autos, building, electronics and packaging, were prepared to pay an additional 5% for a product with green credentials. The pricing power that comes with sustainability is especially pertinent in a world of rising input costs.
Corporates have long battled to improve diversity in the workplace. For example, a 2018 study found that only 16% of IT professionals in the UK were female [iii]. UK-based IT outsourcing firm FDM has won several awards for championing diversity in the workplace. As a result, it has achieved a >30% female workforce and this now acts as a great differentiator in helping clients meet their own diversity goals.
These are just some examples of how ESG can be important to a company’s financial performance and therefore shareholder returns. Once we accept that ESG is a significant long-term driver of value creation (or destruction), it is only logical for it to be incorporated into the investment process.