Why assessing sustainability is too important to outsource

There are a multitude of sources available to investors who want to assess a company’s sustainability. Some of the most commonly used are MSCI, Sustainalytics, and Thomson Reuters. These can be useful for highlighting issues and sourcing data, but I believe in doing my own homework.

My team and I therefore use our proprietary framework, developed and implemented with the help of the Schroders Sustainable Investment Team, to analyse a company’s  ‘Sustainability Quotient’, or SQ. This is one of a suite of proprietary tools designed to aid investment decisions. 

What are we looking for?

Put simply, we understand ‘sustainability’ to mean the durability of a company’s business model over the long term. To put it more succinctly:  ‘what makes a great company stay great?’.

The combination of empirical research and our own experience as investors has led us to believe that sustainability hinges on two key features. Only companies that are run a) for the long term, and b) with regard to all stakeholders, will be able to maintain above average growth and returns.

However, the market tends to be poor at long-term forecasting, rarely looking more than a few years out. Analysts also struggle to make sense of and value non-financial factors because they do not fit neatly into an Excel model.

This means the market often fails to identify or appropriately value those companies that can consistently deliver “supernormal” growth and returns. This offers an opportunity for investors such as ourselves.

But finding these special companies, and deciding which ones to invest in, is not as simple as using third party sustainability ratings. Third party reports can be a useful input for our analysis, but there are serious shortcomings that mean they should be used with caution.

Three problems with third party ratings

1. Third party scores are backward-looking. Our Sustainable Investment Team has produced studies showing that scores are a poor predictor of future controversies, instead tending to change after the event. Scores may also be infrequently updated.

2. Problem two is that third party ratings are inconsistent. Each provider uses a different methodology – which are generally very opaque - and so come up with  different answers, as the chart below shows (AAA-CCC are the different ratings given to companies with AAA being the highest).

3. These third party scoring systems can only be based on reported metrics and policies, given they need to be deployed across a wide range of companies. A lot of the ultimate score relies on whether a company has certain policies or targets in place, regardless of how well they are implemented or achieved. This also means they inevitably reward disclosure rather than a genuine commitment to sustainability. This structure tends to favour larger companies, often in Europe, as these are more likely to have resources dedicated to sustainability reporting and are legally required to have certain policies.

What do we do instead? Introducing the SQ framework

Given the limitations described above, we created our own framework – SQ – for assessing sustainability in a more holistic and unashamedly qualitative fashion.

The framework comprises 20 questions framed around four broad pillars:

Respect for the environment. Here we’re thinking about the company’s impact not just in terms of its products but also its operations – i.e. how it makes those products, runs its facilities etc. We look at whether suppliers are held to high environmental standards, so that a company cannot get a pass just by outsourcing all its dirty work. We also consider any environmental controversies the company has been involved in.

Fair and equitable treatment of employees, suppliers and customers. This covers questions around pay, working conditions, discrimination, and safety. As regards suppliers, we’re looking for evidence of a constructive relationship alongside good visibility and human rights standards down the supply chain. And for customers, product safety and value for money are key areas for consideration, as is the use/protection of any customer data.

Good corporate citizens. We look at the benefits or harm to wider society created by the company’s activities, as well as relationships with regulators and the local community and whether they pay their fair share of tax. We make use of Schroders' proprietary SustainEx tool to quantify this aspect of the assessment (find out more about SustainEx here.

Prudent allocation of capital. This covers aspects such as shareholder returns, governance standards, and transparency.

The purpose of basing the framework around open questions is to move away from simply ticking boxes. These are complex issues that require us to consult a wide range of resources and interact directly with companies. We want to get really ‘into the weeds’ of how a company is run to gain a deep understanding of its corporate culture and stakeholder relationships before we invest.

SQ in practice – high bar for inclusion

Using the SQ framework helps to identify issues and open up different dimensions to the analysis that might not come to the fore in third party reports. We frequently come across companies where we fundamentally disagree with external ratings providers.

For example, our forward-looking analysis might take account of the fact that something has fundamentally changed at the company since a historic controversy, to prevent it from happening again. Or our use of unconventional data and direct company engagement may have given us insight beyond what is disclosed in official reporting – especially in the case of smaller companies or those listed in emerging markets.

Clearly no company is perfect and our SQ framework also helps us to identify areas of relative weakness where we can engage with the company to try and improve their behaviour or practices in the future.   

Truth lies in the eye of the beholder

As the examples above show, any assessment of sustainability is going to be subjective. There is no “absolute truth” that can be revealed just by crunching enough data. 

Our SQ framework means we ask the same 20 questions for every company, regardless of industry or geography. This keeps our approach consistent. However, we recognise that, for a given company, certain questions will be more material than others for the future sustainability of the business.

Looking at a bank, for example, we will pay more attention to assessing their customer relationship management, prudent capital allocation, and their relationship with the regulator – rather than their (modest) environmental footprint. For a food producer, on the other hand, their resource use and sourcing is paramount.

However, there is still value in answering the seemingly less relevant questions for every candidate, as it gives an indication of how seriously the company takes sustainability across the organisation.

Ultimately, we are trying to assess how a company’s management of its stakeholder relationships might translate into its prospects for future growth and returns. The SQ framework provides the lens through which we can do this. Relying on third parties would be like trying to wear someone else’s glasses – we wouldn’t see a clear picture.

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