Conscious Capitalism explained

Conscious Capitalism extends investing beyond the financial statements and incorporates additional factors such as ethics, moral, governance, and environmental or social risks. There are multiple approaches with varying objectives, which makes it confusing for many people exploring the space. This article seeks to resolve this confusion by describing the primary Conscious Capitalism strategies, which are illustrated in the diagram below.

Environmental, Social, and Governance (ESG) Integration

ESG Integration involves identifying an entity’s key ESG risks/factors and analysing how the entity manages those risks/factors. This can be assessed on an absolute basis or relative to the entity’s peers. Companies with clear and appropriate ESG policies and structures, which can also demonstrate behaviour aligned with those policies and structures, have strong ESG credentials.

Boliden (BOL.SE), a Swedish metals and mining company has strong ESG credentials because it has clear commitments and programs to address climate change, water stress, and biodiversity impacts; maintains a zero-fatality record for the five years through 2021, has a fully independent and gender diverse board, and doesn’t have controlling shareholders or special capital structures*.

Peloton Interactive (PTON.US), a US manufacturer of home exercise equipment, is assessed to have poor ESG credentials due to lapses in product safety and quality while its facilities appear to lack certifications from internationally recognized quality standards. In addition, there is no evidence of a dedicated supply chain code of conduct or monitoring programs. Furthermore, there is evidence of misalignment of interests between PTON’s executives and minority shareholders including early vesting provisions for share-based awards, special share classes with unequal voting rights, and shareholders have no rights to call a special meeting*.

We purposely selected a company involved in metal and mining, an activity sometimes shunned by some Conscious Capitalists, to demonstrate strong ESG credentials and a company involved in health and fitness, an activity often sought by Conscious Capitalists, to illustrate weak ESG credentials. This demonstrates that ESG credentials are not determined by how an entity makes money but is rather its adherence to and compliance with ESG factors.

Key point - ESG Integration focuses on an entity’s attitude towards ESG considerations, given its industry, rather than the entity’s core operating activities.

* Source - MSCI ESGManager

Exclusion Screening

Exclusions (aka ‘negative’) Screening involves avoiding entities that generate revenue from an activity that is contrary to an investor’s moral/ethical values. A materiality requirement is normally applied, which means the investor will avoid entities that generate a proportion of revenue from a banned activity that is above a threshold. For example, an investor might avoid companies that generate more than 10% of their revenue from selling tobacco products, while another might have a threshold of 0%, meaning that investor will exclude companies that generate any revenue from tobacco products.

Examples of activities that are regularly part of exclusion lists include: alcohol, animal cruelty, casinos, deforestation, pornography, for profit prisons, manufacturing or distribution of weapons, mining and exploration of fossil fuels and uranium, and tobacco manufacturing.

Selection of the banned activities should primarily reflect the investor’s personal values, which can be controversial as few people share all the same values. For example, Pella excludes companies that make any type of weapon, because we believe all weapons are unnecessary, which is not a view shared by everyone. Pella does not exclude all mining companies, as we believe some commodities (e.g. copper) are necessary for a functional world, which is also not a view shared by everyone.

Key point – Exclusion Screening involves avoiding investing in entities who generate more revenue from an activity than an investor’s personal values/morals allow.

Norms-Based Screening

Norms-Based Screening involves excluding entities that have demonstrated extremely bad behaviour, regardless of the industry they are involved in. Investors often refer to the United Nations Global Compact (UNGC) or the OECD Guidelines for Multinational Enterprises to define good or bad behaviour. However, as with Exclusion Screening, the interpretation of those documents and the ultimate definition of good or bad behaviour is based on the investor’s values.

For example, Pella applied a Norms-Based Screen to exit Visa (V.US) in 2022. Visa’s primary activity is payment processing, which is not an excluded activity, and its ESG credentials are well above average, but it did something that ran contrary to Pella’s values. In essence, there is strong evidence that Visa knowingly processed payments for a company that was alleged to be providing access to child pornography. For a more complete discussion please refer to Pella’s blog, ‘Visa, Porn, and our Red Line’.

Key point - Norms-Based Screening is based on an entity’s behaviour.

Engagement

Engagement involves executing shareholder rights and fiduciary duties guided by ESG considerations. At a minimum, engagement involves participating in all shareholder votes with the votes aligned with ESG considerations. Other forms of engagement include communicating desired ESG behaviours to management/directors and filing shareholder proposals.

As Pella seeks to invest in companies with strong ESG credentials, our approach to Engagement is generally cooperative and we have witnessed satisfactory outcomes from this approach. On the other hand, more activist shareholders seeking to amend a company’s ESG approach often resort to a more aggressive approach. In addition to participating in all shareholder votes, some examples of Pella’s approach to Engagement include writing to all companies in our fund to become signatories of the UN Global Compact, writing to Marsh & McLennan (MMC.US) Board of Directors to request they conduct a study of their exposure to the fossil fuel sector, and requesting retailers to disclose their revenue from selling tobacco products. In contrast, activists such as Elliott Investment Management and Carl Icahn enter proxy battles to make changes to Boards of companies that demonstrate poor corporate governance over an extended period.

Key point - Engagement relates to an investor’s behaviour to contribute to the positive ESG credentials of its investments.

Best-In-Class (BIC)

BIC targets investing in companies that have superior ESG credentials relative to their industry peers. It is essentially an offshoot of the ESG Integration strategy, which is compared in the table below.