Investment manager’s EVP explains how inconsistencies and gaps in current ratings landscape inspired in-house approach
For many firms, the explosion of ratings from the likes of Sustainalytics and MSCI has been a welcome catalyst for ESG integration. But that wasn’t the case for Dixon Mitchell at first.
“We were not early adopters of ESG, mostly because we do all of our own work in-house,” said Don Stuart, the Vancouver-based investment management firm’s executive vice president. “This idea of just taking ESG ratings for our companies, and relying on a third party to say they’re good or bad was not natural for us.”
A Wild West in ESG ratings
Even though ESG investing represented an extra research cost, Stuart said the firm realized how much of the industry was seeing it as a profit centre. Current and prospective clients were also asking more questions about how their investments could make a positive difference in the world.
Looking to build its own in-house process, Dixon Mitchell did a review of ESG ratings in the market. While the world is arguably in the middle of a renaissance in responsible investing, the firm discovered that it was still a Wild West in terms of benchmarks and scoring.
“I think the capital and desire for ESG are moving faster than the tools that are available,” Stuart said. “We found ratings firms were giving very different scores to the same companies. It occurred to us that if we wanted to, we could shop around and find a positive rating for virtually any of the names in our portfolios.”
Stuart suggested that when considering all three pillars of ESG, a disproportionate amount of activity has gone toward the environmental piece. While climate change is certainly an urgent concern, he said fixating on it could lead to ESG ratings that don’t take into account the total impact of a company’s activities.
That has only recently started to change. Social issues have become a greater part of the conversation as the pandemic exposed societal inequities, notably from instances of police brutality and racial discrimination. The global rise in digital technology adoption and the consequent escalation of cybercrime has also made data security a top concern.
“If the infrastructure that people are using is still not mature, companies may just take the opportunity to put a green ribbon on what they do,” Stuart said. “We wanted to make an honest effort for our clients to put ESG and sustainability in our portfolios.”
ESG as the fifth gate
Dixon Mitchell’s evaluation framework starts with determining which ESG factors would be most material for a given company’s business model; a cruise company, for example, would be expected to weigh environmental considerations more heavily than a bank or technology company. After that comes ESG information gathering, which wasn’t as much added work as the firm expected since their portfolios had substantial exposure to small- and mid-cap firms for which ESG rating companies had no scores anyway.
After evaluating and scoring the companies based on 30 different metrics, as well as taking a company’s targets and history of ethical behaviour into account, the firm enters its ratings into a dashboard that ranks each position within the portfolio and tracks their progress over time. The output from that analysis is used as one of five qualitative gating factors that are used to screen holdings.
“A lot of our work is quantitative – looking at balance sheets and income statements, building models, and so on,” Stuart said. “If a company is too far gone from an ESG perspective, and they’re not moving in the right direction, we’re less likely to do significant additional work on it.”
Beyond doing deep ESG research on companies and divesting from laggards, Dixon Mitchell strives to influence corporate behaviour and management progressiveness. On top of making frequent use of its shareholder votes to endorse ESG-positive initiatives and executives, it consults with the management teams of its portfolio companies. With more than 100 meetings conducted with executive teams each year, the firm has ample opportunity to encourage sustainable behaviour and gauge a company’s commitment and attitude toward ESG.
“We’ve always seen ourselves as a buyer of businesses, so we want to know the people running the ones we have a stake in,” Stuart said. “Right now, we feel like we know all of our companies and management teams better than we did before – some for better, some for worse.”
Heroes among ESG 'zeroes'
Stuart shared the example of Badger Daylighting, a Canadian small-cap company that doesn’t even register on the large ESG ratings firms’ screens.
It turned out that the company has a number of significant partnerships with Indigenous communities, but hadn’t published them in a formal Corporate Social Responsibility (CSR) report. With Dixon Mitchell’s encouragement, the company now has its own CSR report that highlights these and other positive initiatives and which provides the data required by the ESG rating agencies.
“If we had looked at them and said ‘we’ll just go by what the ratings firms say,’ then we would have seen them as essentially a zero, when in fact they had some great stories to tell,” Stuart said.
The current momentum in ESG, he said, marks a crossroads for the business and investment world. Businesses could choose to be better stewards of assets and corporate citizens, or engage in corner-cutting and profiteering. Investment firms, meanwhile, could either make genuine strides toward ESG integration, or seize it as a marketing opportunity while setting the lowest targets possible.
“I can confidently say that the momentum is not going away,” he said. “No one will argue that younger people aren’t more attuned to these issues than previous generations. As massive amounts of wealth pass on to them, I think there’s very little chance of this movement slowing down.”