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Finding Value in ESG (4Q 2022)

08 February 2023

8 min read

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Deep research and engagement can help value investors capitalize on controversy and access a potential source of alpha. The Pzena Opportunity List represents our belief in our ability to push for better outcomes by engaging with the companies we own.

The driving force behind the development and application of the Pzena Opportunity List is the belief in our ability to push for better outcomes by engaging with the companies we own. Deep research and extensive engagement are cornerstones of our investment philosophy and critical components of our process as long-term active investors. They can help us capitalize on controversy and access a potential source of alpha. The below serves as an abbreviated version of the full report on the Opportunity List, which can be found on the Pzena website.

ESG PROCESS AND ENGAGEMENT

We engage with each company in our investment portfolios, both as a part of our pre-investment diligence process and on an ongoing basis to monitor progress. The Pzena Opportunity List seeks to systematically identify opportunities in our portfolio where material ESG issues exist, and engagement could have a positive impact. Similar to our valuation screens where we rely on company and industry history to naively forecast future earnings, the Opportunity List uses the MSCI score, independence of the directors making up the board’s audit committee1, scope 1 and 2 carbon intensity, and compliance with United Nations Global Compact (UNGC) principles to flag potential Opportunity List candidates. We expect these inputs to evolve over time as disclosures, ratings, and data improve.

As part of our diligence, the industry analyst will assess the reasons that the company was flagged. Ultimately, it is our own proprietary research that decides the final Opportunity List status for a given company. This consensus is arrived at during the final stages of our research process and requires unanimity of the industry analyst, ESG analyst, and portfolio managers. Once a company is placed on the Pzena Opportunity List, we create an engagement plan with specific objectives and milestones to track progress.

TRACKING INCREMENTAL PROGRESS

In practice, progress against the engagement plan will not manifest all at once but will appear in incremental steps over the investment time horizon. If we see a company is trending off-track, we have several options to escalate engagement. Persistent failures to address our concerns could lead to our reevaluation of the investment thesis and potential divestment. As part of our ongoing monitoring, companies on the Opportunity List get formally reviewed every six months with the industry analyst, portfolio managers, and ESG analysts to decide whether a company should remain on the Opportunity List. This semi-annual review also affords the analyst a forum to consider if any existing companies not currently on the Opportunity List should be added. Industry analysts are constantly monitoring new developments at companies and can recommend any changes within their coverage as developments emerge.

In some cases, removal from the Opportunity List will come with the gradual resolution of the ESG issue(s) over time and/or only require discreet changes, such as the resolution of a pending litigation. In many other cases, removal is more nuanced and requires continuous research, engagement, and monitoring. Both cases require us to be in dialogue with management and to respond to changes that may impact the range of investment outcomes.

We do not believe there is a one-size-fits-all approach to company engagement or that there is one way to measure progress at the individual company level. The examples below are meant to highlight the ongoing engagements we have with Opportunity List companies, with further details provided in the long-form version on our website.

Isuzu
We added Isuzu to the Opportunity List at the end of 2021 with the goal of encouraging management to
set a coherent electric vehicle (EV) transition strategy. Through multiple engagements in 2021, we monitored the steps management was taking to advance their EV strategy. In Q2 2022, Isuzu published its plan to achieve carbon neutrality in operations, beginning with a goal to halve scope 1 and 2 CO2 emissions by 2030. Additionally, management set a timeline to research and develop the conversion of the product lineup of light-duty and heavy-duty trucks and buses to electric and hybrid models with short and medium-term development targets. This convinced us that management was appropriately positioning the business for the EV transition, and capex plans and timeline seemed reasonable. With this determination, we removed Isuzu from the Opportunity List, but will continue to engage with management to ensure the company is following through on the stated plan.

Hon Hai
In December 2022, we made the decision to add Hon Hai to the Opportunity List given the escalating number of labor-related controversies. As a mobilizer of a large low-cost labor force, labor is both a critical business resource and potential risk factor for Hon Hai. From a business perspective, ensuring a supply chain that meets international standards is critical to the long-term success of Hon Hai. We therefore consider social issues a tail risk that we need to continue to monitor. Several highly publicized labor-related controversies have occurred in the last three years. While we are disappointed to see a recurrence of labor-related issues, we are pleased that Hon Hai is now more proactive in disclosing information and discussing these incidents with shareholders. We maintain an ongoing dialogue with the company on labor issues and continue to assess the risk of Hon Hai losing market share.

Alibaba
Alibaba has a history of governance lapses which contributed to our decision to add it to the Opportunity List in Q4 2021. These have included issues related to business ethics and related party transactions, as evidenced by the partial transfer of control of Ant Group to Jack Ma in 2011. Given Alibaba’s history, we feel that continued responsiveness to shareholder concerns and the passage of time without incident will be the best measurement of their progress on ethics and governance.

CONCLUSION

At Pzena, our focus will always be on the material issues facing a company, ESG or otherwise, that may be contributing to current underperformance. If those issues are temporary and/or can be remediated, the company may be an interesting investment opportunity. The Opportunity List consists of a subset of our portfolio companies where ESG issues are among the most material issues facing the company. Improvement in these ESG issues, aided by our engagement efforts, could therefore lead to improvement in company earnings. However, there is no guarantee of ESG improvement for companies on the Opportunity List and they may remain on the Opportunity List for a range of timeframes. Regardless of outcome, we maintain that the most important thing is to continue to advocate for change if we believe it is in the interests of long-term shareholders to do so.

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FURTHER INFORMATION

These materials are intended solely for informational purposes. The views expressed reflect the current views of Pzena Investment Management (“PIM”) as of the date hereof and are subject to change. PIM is a registered investment adviser registered with the United States Securities and Exchange Commission. PIM does not undertake to advise you of any changes in the views expressed herein. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance is not indicative of future results.

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All investments involve risk, including loss of principal. Investments may be in a variety of currencies and therefore changes in rates of exchange between currencies may cause the value of investments to decrease or increase. The price of equity securities may rise or fall because of economic or political changes or changes in a company’s financial condition, sometimes rapidly or unpredictably. Investments in foreign securities involve political, economic and currency risks, greater volatility and differences in accounting methods. These risks are greater for investments in
Emerging Markets. Investments in small-cap or mid-cap companies involve additional risks such as limited liquidity and greater volatility than larger companies. PIM’s strategies emphasize a “value” style of investing, which targets undervalued companies with characteristics for improved valuations. This style of investing is subject to the risk that the valuations never improve or that returns on “value” securities may not move in tandem with the returns on other styles of investing or the stock market in general.

This document does not constitute a current or past recommendation, an offer, or solicitation of an offer to purchase any securities or provide investment advisory services and should not be construed as such. The information contained herein is general in nature and does not constitute legal, tax, or investment advice. PIM does not make any warranty, express or implied, as to the information’s accuracy or completeness. Prospective investors are encouraged to consult their own professional advisers as to the implications of making an investment in any securities or investment advisory services.

The specific portfolio securities discussed in this presentation are included for illustrative purposes only and were selected based on their ability to help you better understand our investment process. They were selected from securities in one or more of our strategies and were not selected based on performance. They do not represent all of the securities purchased or sold for our client accounts during any particular period, and it should not be assumed that investments in such securities were or will be profitable. PIM is a discretionary investment manager and does not make “recommendations” to buy or sell any securities. There is no assurance that any securities discussed herein remain in our portfolios at the time you receive this presentation or that securities sold have not been repurchased.

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This marketing communication is issued by Pzena Investment Management, Ltd. (“PIM UK”). PIM UK is a limited company registered in England and Wales with registered number 09380422, and its registered office is at 34-37 Liverpool Street, London EC2M 7PP, United Kingdom. PIM UK is an appointed representative of Mirabella Advisers LLP, which is authorised and regulated by the Financial Conduct Authority. The Pzena documents are only made available to professional clients and eligible counterparties as defined by the FCA. Past performance is not indicative of future results. The value of your investment may go down as well as up, and you may not receive upon redemption the full amount of your original investment. The views and statements contained herein are those of Pzena Investment Management and are based on internal research.

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This marketing communication is issued by Pzena Investment Management Europe Limited (“PIM Europe”). PIM Europe (No. C457984) is authorised and regulated by the Central Bank of Ireland as a UCITS management company (pursuant to the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations, 2011, as amended). PIM Europe is registered in Ireland with the Companies Registration Office (No. 699811), with its registered office at Riverside One, Sir John Rogerson’s Quay, Dublin, 2, Ireland. Past performance is not indicative of future results. The value of your investment may go down as well as up, and you may not receive upon redemption the full amount of your original investment. The views and statements contained herein are those of Pzena Investment Management and are based on internal research.

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