Q&A: Staying Relevant With ESG Analysis

Editor’s note: This is one in a series of Q&As with financial professionals about how they’re incorporating environmental, social, and governance factors into their investing approaches and their views on ESG risk.

Todd Ahlsten comanages Parnassus Core Equity Fund PRBLX, which earns a Morningstar Analyst Rating of Silver and has a Morningstar Sustainability Rating of 5 globes. The fund has been notable for its low volatility and downside risk relative to its peers.

You emphasize downside risk in your process. How does ESG analysis factor in? ESG is totally integrated with our risk management. We invest in high-quality businesses that can grow through cycles. ESG informs us of quality, starting with governance and how boards are constructed and capital is allocated. Human capital is vital to building a business and innovating and disrupting and creating value. We avoid companies that really retrench in downturns. Companies that don't make deep cuts to their workforce in a downturn are able to gain market share when the economy bounces back. It's a business model that's linked to governance.

When it comes to carbon risk, you can think either offensively, investing for solutions, or defensively, reducing downside risk with less carbon intensity. Our team sifts out areas where we could be on the wrong side of history. The effect of ESG on risk has been expressed in both what we own and what we have chosen not to own. Take 2008, for instance. We felt that lenders were pushing the envelope on ethical lending practices, so we were very underweight in the financial-services industry. That was a big part of our outperformance that year.

How do companies that pass your ESG screens compare with others within the same industry? I'll give you an example in the industrial space. We held 3M MMM for quite some time. It is doing innovative things on climate and autonomous driving vehicles and safety and the electric grid. Then, our risk research showed that PFAS chemicals were going to be an overwhelming environmental liability, not only from the litigation standpoint but potentially a reputation standpoint. We ended up divesting our 3M position. Then, there's Xylem XYL, an industrial company that offers opportunities in water infrastructure that are generational. It's a fantastic business that we think can compound value for a long time. Both companies are innovating, but one company has emerging risks that we think will break the wrong way. The other company is not only providing solutions but gives us downside protection. That's our alpha generation machine: to not own 3M and to own Xylem.

Did ESG risk factor into your recent decision to avoid fossil fuels? Absolutely. There's a collection of financial risks with fossil fuels: commodity risk, economic risk, leverage, and the fact that value is largely under the ground, which means long-term discounted cash flow risk. On top of that are the ESG risks that the financial metrics might not be capturing: climate change, regulation, public opinion, politics, taxes, and royalties. The risk of impaired assets is very significant; climate change is going to cause demand issues for fossil fuels.

Are the companies you engage with receptive to the idea that ESG issues can be business risks? A lot of them are. Our ESG analysts attend the lion's share of our meetings and phone calls with management. We are letting these companies know what we see and what it means.

We own some utilities in Parnassus Mid Cap PFPMX that have among our highest-risk ESG scores. For some of them, it’s merely a disclosure issue, so we’re working with them on how they're disclosing their missions and what they’re investing in. They are interested in our perspective, especially when it’s backed by gold-plated third parties like Morningstar and Sustainalytics.

When we visited Disney DIS, Bob Iger joined the meeting because he wanted to hear about how we looked at ESG and risks. Content drives the company, and we want to make sure the company maintains integrity there. Disney is still a family-oriented brand; they’re thoughtful about how to invest in quality content that is in line with the company's history and value as a brand. Second, there are issues of worker compensation and safety in the theme parks. And third, there is the environmental footprint of the parks and the cruise ship business.

If investors focused less on quarterly earnings and more on longer-term metrics, would they be more likely to align with your point of view? Yes. We've owned Sysco SYY for 15-plus years, and we've had a very rich engagement with them on safety and worker rights in seafood and shrimp farming in Asia. We're looking at drivers that can make the company better over the next three to 10 years. Engagements don't happen in one phone call. If you're going to have real dialogue as an ESG investor, it's got to be long term. That's where the alpha generation typically comes from. It's a mindset.

The fossil fuel decision is an example of how important it is to look at the long term. Relevancy over the long term drives a sustainable business. Relevancy screens will help drive upside participation and also downside protection. There’s going to be a lot of disruption in our economy over the next 10 to 20 years, and we want to avoid industries in secular decline. You can’t double down on relevancy without doubling down on ESG. In 10 years, is this company going to be there for me or not?

This article originally appeared in the first-quarter 2020 issue of Morningstar magazine. Learn how financial professionals can subscribe for free.