ACTIVE VIEWPOINT ETHICAL INCOME OCTOBER 2017 FOR WHOLESALE CLIENTS ONLY KEEPING ETHICAL BEHAVIOUR ON WATCH Will Baylis Portfolio Manager, Martin Currie Australia Reece Birtles Chief Investment Officer, Martin Currie Australia In this paper we provide insight into how ESG research is integrated into our investment process, and how the Ethical Values and ESG Impact screens operate to keep a watch on the ethical behaviour of the companies in our investment universe. We provide a selection of company examples to help clients better understand the implications of an ethical screen being applied to an investment strategy. We believe in an investment approach that makes Environmental, Social and Governance (ESG) factors real, with analysis and active ownership fully embedded in the investment process and implemented directly by our portfolio managers. www.martincurrie.com
A CLIENT DRIVEN ETHICAL SOLUTION The Martin Currie Australia Equity Income strategy was established in May 2010 and our Ethical Income strategy was launched in December 2015. Both strategies were created through collaboration with our clients based on their needs. Client-driven demand for an ethical income strategy has come from discussions with charities, foundations, adviser platforms, who, like the retirement-focused clients we worked with for Equity Income, needed sustainable and low risk income. However, our Ethical Income clients also required their investment portfolio to exclude companies that contravene their own ethical values and beliefs. Martin Currie Australia has blended our clients ethical values with the existing Equity Income investment process to deliver an income solution that provides for both ethical values and income needs. We believe that the inclusion of ethical values does not compromise the income objective of providing a yield with franking credits at least 20% greater than the S&P/ ASX 200 and to grow dollar income above inflation (as measured by the Consumer Price Index). EFFECTIVE STEWARDSHIP OF CAPITAL IS AT THE HEART OF OUR CLIENT PROPOSITION We believe in an investment approach that makes Environmental, Social and Governance (ESG) factors real, with analysis and active ownership fully embedded in the investment process and implemented directly by our portfolio managers. We look to positively influence corporate behaviour and governance, living these values through the management of our own business. As a signatory to the Principles for Responsible Investment (PRI) since 2009, we have integrated ESG analysis into our investment research process. Stewardship is a critical part of our philosophy. It is evident at every stage of our investment process, in particular our approach to engagement and voting activity. ETHICAL VALUES AND ESG IMPACT SCREENS Working with our clients and their values, the screens have been constructed as follows: Ethical values screen Companies with revenues related to any one of the following activities that represent more than 5% of the company s total revenue, or revenues from a combination of any of the following activities that represent more than 10% of the company s total revenue: alcohol; adult entertainment; defence and weapons; fur; gambling; genetically modified crops; nuclear power; or tobacco. ESG impact screen Companies that generate more than 20% of total earnings before interest, tax, depreciation and amortisation (EBITDA) from thermal coal power generation, or generate more than 20% of revenue from thermal coal mining; Companies that do not operate in accordance with widely accepted international norms and principles; or Companies with a red flag for very severe ESG impact on stakeholders: Environmental controversies; Social controversies; Human rights & community; Labour rights & supply chain; Customers; or Governance controversies. Additional Ethical Values with Income Screen Catholic Health Australia Code of Ethical Standards Stewardship is a critical part of our philosophy. It is evident at every stage of our investment process, in particular our approach to engagement and voting activity. 02
ESG IS ALREADY PART OF OUR PROCESS By incorporating ESG factors into our assessments for each stock through our deep fundamental analysis, we can enhance our ability to deliver sustainable long-term investment performance for our clients. Our analysts use both proprietary and external research (such as MSCI and Ownership Matters) to uncover potential ESG issues. This research helps the analysts to formulate proprietary Martin Currie Australia ESG rankings. These ESG rankings are incorporated into both the quality rating applied by our analysts. For example, as part of quality, a business strength assessment is conducted by our analysts on each individual security. This is combined with a 32-factor checklist that takes into account leverage, earnings quality, management and ESG standards. These ESG rankings are incorporated into both the quality rating applied by our analysts. For example, as part of quality, a business strength assessment is conducted by our analysts on each individual security. This is combined with a 32-factor checklist that takes into account leverage, earnings quality, management and ESG standards. ESG factors also directly impact cash flow forecasts used for each security s valuation. Issues such as potential penalties for environmental damage, executive pay, litigation costs are considered. Furthermore, this quality rating applied by our analysts impacts the stock-specific discount rate, and the strategy will take larger positions in stocks with a higher-quality rating. Carbon emissions trading Carbon emissions trading Gender diversity Water usage Potential for criminal litigation Water usage Related party transactions Quality risk assessment Transparency & disclosure Executive pay Impact on sustainable earnings/valuation Certified sustainable forestry Absence of progression Board structure Employee safety Penalties for environmental damage ACTIVE VIEWPOINT: ETHICAL INCOME 03
THE ESG ISSUES WE LOOK FOR Whilst ESG issues are generally unique to each company, some of the issues we consider include: Environmental Environmental impact of products and services uranium, logging, mining Carbon footprint, greenhouse gas emissions Use of plastics, packaging, genetically modified food and non-renewable energy Pollution levels to air, land, and water Potential climate change impact on industry insurance Penalties for environmental non-compliance Environmental reporting and management Environment awards Social Community relations Human rights Indigenous issues Involvement in weapons and defence Products associated with social problems alcohol, tobacco, gaming and obesity Employee relations occupational health & safety, employee share schemes Discrimination, unfair dismissal and union disputes Governance The chairman s track record Board experience and independence Incentives Compensation Board/management related party transactions Competency of key personnel Company culture and strategy ETHICAL SCREEN IN ACTION The Ethical and ESG Impact exclusionary screens are an extension of our ongoing focus on ESG. We have found that our income universe of around 120 stocks was already complementary to the needs of the ethical portfolio, with only a further 21 stocks excluded by the Ethical Values and ESG Impact screen, and only five of these would have been included in a standard Equity Income portfolio (as at 30 September 2017). These include:1 AGL (on thermal coal revenue grounds); Coca Cola Amatil, Woolworths and Wesfarmers (for alcohol revenue); and Tatts Group (for gambling revenue). KEEPING BEHAVIOUR ON WATCH To help demonstrate the implications of ethical screens being applied to an income strategy, the following stock examples are excluded from our income universe by the screens. It may be surprising to realise that some of these stocks in fact breach the ethical screens. The primary source for company ESG ratings and valuations is the 12-member ESG, portfolio manager and research team at Martin Currie Australia who have extensive experience in their fields. In the following examples, the use of MSCI reports provides further external validation of our own analysis around sustainability, ESG and earnings thresholds. ETHICAL VALUES SCREEN EXAMPLES The Ethical Values screen excludes companies with greater than 5% revenue from tobacco. Whilst not currently held in our Equity Income portfolios, Amcor forms part of our larger income universe. You may be surprised to find out that it derives almost 15% of revenue from tobacco packaging! As the only manufacturer with a global footprint, the business is very well positioned to support customers as they focus on premiumisation of (tobacco) brands. 2 According to MSCI, it was only in May 2016, that the company officially confirmed the percentage of revenue derived from tobacco based on disclosures made by the company through MSCI ESG Research data verification process.3 1The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable. 2Company reports. 3Martin Currie Australia, MSCI, company reports. 04
The Ethical Values screen excludes companies with greater than 5% revenue from alcohol. Our estimates find that Coca-Cola Amatil (CCL) derives over 7% of revenue from the production and distribution of alcoholic beverages.4 CCL manufactures Jim Beam & Cola, an alcoholic beverage, through its partnership with Beam Global Spirits & Wines. The company also owns a distillery and breweries that manufacture beer and rum under the brands Fiji, Vailima, and Bounty. Additionally, the company also distributes a variety of whisky brands, including Jim Beam, Canadian Club and Kilbeggan. ESG IMPACT SCREEN EXAMPLES Our ESG Impact screen excludes electricity power companies where coal fired power generation is in excess of 20% EBITDA and mining companies where coal mining exceeds 20% of revenue. AGL acquired Macquarie Generation in September 2014, resulting in over 40% of EBITDA now derived from coal powered electricity generation.5 AGL presents us with a slight quandary. Whilst this is a stock that we consider high quality, and hold in our standard Equity Income portfolios, it is both a large user and producer of so-called dirty coal and also one of the largest developers of renewable energy streams. The company has stated that starting in 2022 and ending by 2050, AGL is getting out of coal, which we fully support, but as a consequence of its current reliance on thermal coal in its energy production, we have removed AGL from Ethical Income portfolio. However, we have also found good substitution of the New Zealand integrated electricity utilities that use predominately cleaner renewable energy for power generation. Examples include Mercury Power. Our ESG Impact screen excludes any company red flagged by MSCI for very severe ESG impact on stakeholders. Whilst not currently held in our Equity Income portfolios, Ansell forms part of our larger income universe. Until recently, Ansell had a red flag for labour/ employee issues in Brazil and Malaysia where they manufacture which also excluded it from the Ethical Income portfolio. The previous red flag has now been removed due to resolutions with labour unions in the respective countries where manufacturing takes place. According to a recent MSCI report: The assessment was upgraded in April 2017, as there had been no further recurrence of labour controversies following on the company s August 2016 agreement with the Industrial labour group to reinstate Sri Lankan workers dismissed in 2013. The company also responded to allegations lodged in an OECD complaint, either denying or declaring that they had already been addressed. Industrial has indicated that the MOU fully addresses its OECD complaint. The company also indicated that labour issues in Brazil and Malaysia had also been resolved. Ansell has faced recurrent protests from various labour unions at its facilities in Sri Lanka, Malaysia, and Brazil. The groups representing Ansell workers in these countries highlighted widespread and deeply rooted concerns regarding the company s alleged failure to resolve longrunning labour disputes and recognize the fundamental labour right of employees to bargain collectively. 6 POSITIVE CONSIDERATION OF ESG FACTORS Importantly, while the Ethical Income strategy incorporates the exclusionary screens above, it also includes a positive consideration of ESG factors which is included in our analysts individual stock quality assessment and risk adjusted valuation. The New Zealand integrated electricity utilities such as Mercury Power mentioned earlier is an example where our higher-quality rating on its Environmental credentials has improved its position in the portfolio. The ASX is another top-10 shareholding in our Ethical Income strategy where its higher-quality Governance is important. As part of our overall Quality assessment, we engage regularly with management and form our own views on the competency of board, management and culture of the company. Our financial analysts responsible for the ASX had already identified a strong corporate culture, competent board and management, which has more recently been corroborated by MSCI. MSCI recently stated: ASX has been upgraded to AA from BBB. ASX has improved its corporate governance practices, particularly for its audit committee which now has an industry expert, is fully independent and does not contain executives or members who are over-boarded. 7 The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable. 4Martin Currie Australia. 5Source: Martin Currie Australia, MSCI, company reports. 6Source: MSCI Report April 2016. 7Source: MSCI Report February 2017. ACTIVE VIEWPOINT: ETHICAL INCOME 05
THE IMPORTANCE OF GOOD STEWARDSHIP Reflecting the importance of ESG issues, Martin Currie has been signatories to the UN-supported Principles for Responsible Investment (PRI), a worldwide initiative comprising asset owners, investment managers and service providers, since 2009. Furthermore, in July 2017 the PRI awarded Martin Currie an A+ (highest performance band) for each of the three top-level categories: strategy and governance, incorporation and active ownership. Given Martin Currie Australia s emphasis on stewardship and active ownership, this is a significant endorsement. INCOME: THE ETHICAL WAY The Martin Currie Australia Ethical Income strategy has been designed to suit a wide variety of investors with strong ethical values, and a requirement for highquality, low risk income. ESG research is fully integrated into our investment process, and the ethical values and ESG Impact screens operate together with this deep fundamental research to keep a watch on the behaviour of the companies in our investment universe. The Ethical Income strategy forms part of MCA s A$13 billion income solutions book, which also includes the equity income, real income and multi asset retirement income strategies. In total MCA manages over A$15 billion for domestic and international clients (as at 30 September 2017). Approach A+ Integration A+ Active ownership A+ The Martin Currie Australia Ethical Income strategy has been designed to suit a wide variety of investors with strong ethical values, and a requirement for high-quality, low risk income. ACTIVE VIEWPOINT is just one part of our range of investment materials. To access further perspectives on our strategies and key investment themes, visit: www.martincurrie.com FIND OUT MORE For further information on the Martin Currie Australian equities range please visit our website www.martincurrie.com You can find your local contact at www.martincurrie.com/contact_us Alternatively please call: Kimon Kouryialas Head of Pan Asia T: 61 (0) 3 9017 8640 M: 61 (0) 417 377 431 kkouryialas@martincurrie.com.au 06
IMPORTANT INFORMATION This information is issued and approved by Martin Currie Investment Management Limited ( MCIM ). It does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested. Past performance is not a guide to future returns. The document may not be distributed to third parties and is intended only for the recipient. The document does not form the basis of, nor should it be relied upon in connection with, any subsequent contract or agreement. It does not constitute, and may not be used for the purpose of, an offer or invitation to subscribe for or otherwise acquire shares in any of the products mentioned. The information contained has been compiled with considerable care to ensure its accuracy. No representation or warranty, express or implied, is made to its accuracy or completeness. Martin Currie has procured any research or analysis contained in this document for its own use. It is provided to you only incidentally and any opinions expressed are subject to change without notice. Some of the information provided in this document has been compiled using data from a representative account. This account has been chosen on the basis it is an existing account managed by Martin Currie Australia, within the strategy referred to in this document. This data has been provided as an illustration only, the figures should not be relied upon as an indication of future performance. The data provided for this account may be different to other accounts following the same strategy. The information should not be considered as comprehensive and additional information and disclosure should be sought ahead of any planned investment. The distribution of specific products is restricted in certain jurisdictions, investors should be aware of these restrictions before requesting further specific information. Please note the information within this report has been produced internally using unaudited data and has not been independently verified. Whilst every effort has been made to ensure its accuracy, no guarantee can be given The opinions contained in this document are those of the named managers. They may not necessarily represent the views of other Martin Currie managers, strategies or funds. Investors should also be aware of the following risk factors which may be applicable to the strategy shown in this document. These strategies may hold a limited number of investments. If one of these investments falls in value, this can have a greater impact on the strategy s value than if it held a larger number of investments. Investing in foreign markets introduces a risk where adverse movements in currency exchange rates could result in a decrease in the value of your investment. Smaller companies may be riskier and their shares may be less liquid than larger companies, meaning that their share price may be more volatile. Income strategy charges are deducted from capital. Because of this, the level of income may be higher but the growth potential of the capital value of the investment may be reduced. Any distribution of this material in Australia is by Martin Currie Australia ( MCA ). Martin Currie Australia is a division of Legg Mason Asset Management Australia Limited (ABN 76 004 835 849). Legg Mason Asset Management Australia Limited holds an Australian Financial Services Licence (AFSL No. AFSL240827) issued pursuant to the Corporations Act 2001. Martin Currie Investment Management Limited, registered in Scotland (no SC066107) Martin Currie Inc, incorporated in New York and having a UK branch registered in Scotland (no SF000300), Saltire Court, 20 Castle Terrace, Edinburgh EH1 2ES Tel: (44) 131 229 5252 Fax: (44) 131 222 2532 www.martincurrie.com Both companies are authorised and regulated by the Financial Conduct Authority. Martin Currie Inc, 620 Eighth Avenue, 49th Floor New York, NY 10018 is also registered with the Securities Exchange Commission. Please note that calls to the above number may be recorded.