What might happen if companies had to pay for the damage they cause?
Economists define an ‘externality’ as a consequence of industrial or commercial activity that affects other parties – but that is not reflected in market prices. Many investors want reassurance that the companies their fund managers select do not damage either society or the environment while creating wealth. These costs are seldom included in the financial statements of companies and should, in our view, be added into a fundamental valuation.
The most common example of an externality is pollution. As a social cost, pollution has long been recognised by governments, which have introduced legislation and imposed a range of fines and sanctions on many polluting companies. The current environmental debate often fails to recognise how effective this has been. Air quality in London may still be below best standards, but the ‘pea-soup’ fogs from coal-burning were eliminated by the Clean Air Act of 1956. Similarly, the improved water quality of the Thames, from clamping down on industrial pollution, has led to a sharp increase in sightings of seals, otters and, occasionally, even whales chasing fish.
There are, however, calls for broader sanctions – to cover issues such as soil and water degradation by intensive farming or forestry.
Companies at risk of penalty could cover the potential costs within their accounts under ‘contingent liabilities’ or under ‘legal risks’; but accountants tend to record only ongoing legal matters and highly likely costs. Historically, environmental penalties have been quite unlikely but hugely expensive events. In 2009, BP’s accounts had a provision for environmental remediation of $588 million. The Deepwater Horizon oil spill the following year cost BP around $20 billion.
Understanding risk from an investment perspective…
For some time, assessing and judging externalities and the totality of risk they might pose to any investment has been central to thorough, fundamental analysis. This needs to cover social and environmental costs that may be understated or not reflected at all in accounts drawn up to current accounting standards. This depth of analysis is not the product of some moral crusade. Establishing a more accurate appreciation of a company’s benefits and costs to society and the environment helps us understand more fully the potential threats to shareholders’ returns.
Widening the net…
The concept of externalities is particularly useful when trying to focus on the unrecognised damage that economic growth can cause. It highlights the areas of the Environmental, Social and Governance (ESG) programme that should be included in any fundamental valuation. Such externalities can also include public safety and health issues (e.g. cancer from smoking), sourcing externalities (e.g. battery manufacturing for electric cars), climate change (e.g. airline fuel pollution), overuse of common assets (e.g. over-fishing) and long-term liabilities (e.g. storage of nuclear waste).
All such issues can be reflected in a thorough financial analysis of a company and then assessed for their materiality – even though many aspects of accounting for externalities require creative thinking and experience. This is similar to other aspects of the ESG programme that are difficult to incorporate in valuation; but which often form part of one’s overall risk assessment of a company. A board lacking diversity is not making the best of its human resources, but this effect is hard to quantify. Governance issues such as political risk in emerging markets can have a material impact on portfolios. That said, the common sense approach is to limit a portfolio’s exposure to such countries and companies, rather than guess at, say, the likelihood of sharp falls in a currency. Many criticisms of social media companies – from their causing teenage anxiety to biased political coverage – offer further examples of externalities whose financial scale is very hard to assess, but which may pose significant financial risk to shareholders.
It is not all negative. Some companies also have positive externalities, through which the benefits they do to society or our environment may not be captured in their profits. Railway companies reduce the freight that would be on the roads; immunotherapy companies reduce the overall cost of cancer treatments while giving many cancer patients a much fuller recovery than previous treatments. Where we can, we look for such investments, as we think these should form the backbone of a sustainable investment portfolio.
The Artemis Global Select Fund and Mid Wynd International Investment Trust aim for sustainable and consistent investment returns. That is why we have always tried to include in our investment analysis all factors that threaten these returns. Improved data from companies, especially on ESG factors, has allowed us to include more objective and up-to-date data about these aspects, alongside data about profitability and competitiveness. The data improves our ability to challenge management on business sustainability, but screening and ‘ESG scoring’ cannot replace an evaluation of each company in context. We believe that a portfolio built from companies with strong businesses that do more good to society than harm is the way to achieve sustainable and reliable investment returns.
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Risks specific to the Artemis Global Select Fund
The fund may have investments concentrated in a limited number of companies, industries or sectors. This can be more risky than holding a wider range of investments.
The fund may invest in emerging markets, which can involve greater risk than investing in developed markets. In particular, more volatility (sharper rises and falls in unit/share prices) can be expected. The fund may invest in China A-shares (shares traded on Chinese stock exchanges in Renminbi). There is a risk that the fund may suffer difficulties or delays in enforcing its rights in these shares, including title and assurance of ownership. The fund is an authorised unit trust scheme. For further information, visit artemisfunds.com/unittrusts.
Risks specific to Mid Wynd International Investment Trust
Please ensure that you understand whether this fund is suitable for you. We recommend that you get independent financial advice before making any investment decisions. This information does not constitute an offer, invitation or solicitation to deal in the securities of this fund.
The fund may invest in emerging markets, which can involve greater risk than investing in developed markets. In particular, more volatility (sharper rises and falls in unit/share prices) can be expected. The fund may invest in the shares of small and medium-sized companies. Shares in smaller companies carry more risk than larger, more established companies because they are often more volatile and, under some circumstances, harder to sell. In addition, information for reliably determining the value of smaller companies – and the risks that owning them entails – can be harder to come by. The fund may borrow money to make further investments, an investment approach known as ‘gearing’. This can enhance investment returns in rising markets but will reduce returns when markets fall.
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