Invest for good: Sentio’s unique approach to ESG investing

SANVEER HARIPARSAD Portfolio Manager and Head of Fixed Income, Sentio Capital Management

ESG is here to stay

At Sentio, we subscribe to the fact that ‘wealth creation’ has evolved beyond just financial returns and asks the question, “How are returns generated and what are the consequences for society and the environment?” Consequently, we believe that greater awareness and incorporation of ESG by investors will enable a more efficient allocation of capital and contribute towards a more sustainable and inclusive economy.

The term ‘ESG’ is commonly associated with sustainable investing and has recently grown in popularity due to the increase in corporate fallouts like Steinhoff and Tongaat that, in turn, have led to several ESG frameworks being developed.

Sentio’s customised ESG framework

To provide a more holistic risk assessment, ESG risk measures need to be integrated with an understanding of the qualitative aspects of ESG, which we refer to as ‘Following the Timeline’. In the examples of Steinhoff and Tongaat, merely analysing annual reports would not have been sufficient to provide an early indication of the embedded risk.

When assessing risk, we believe there are other qualitative factors that need to be considered that are not included in a traditional ESG framework, such as the restatement of financial statements, corporate culture and management integrity. In fact, the corporate failures mentioned earlier ticked all the traditional ESG boxes, which is concerning given what materialised. Taking the above into consideration, our customised framework calculates a quantitative score of each company’s ESG record based on both our qualitative risk measures and traditional ESG metrics.

Application of Sentio’s fixed-income process

In addition, Sentio’s fixed-income approach integrates our customised ESG, equity and credit processes, which allows us to make more informed investment decisions by quantifying and correctly pricing the embedded risk in all debt instruments. We do this by integrating the customised ESG framework with a rigorous quantitative analysis, using tools like ‘Altman-Z’ and ‘Distance-to-Default’ to arrive at a composite internal credit rating for each issuer. This is then compared to an external rating, which helps us better assess the value of any instrument.

THE TERM ‘ESG’ IS COMMONLY ASSOCIATED WITH SUSTAINABLE INVESTING AND HAS RECENTLY GROWN IN POPULARITY

Sasol is a great example of the effectiveness of Sentio’s process. In 2019, Sasol issued their first locally listed debt instrument with a AAA credit rating (the highest quality rating), but according to Sentio’s integrated fixed-income process, this rating was not justified, given the embedded governance risk. Firstly, these debt proceeds were going to be used for Sasol’s Lake Charles Chemical Project (LCCP) in the US, which meant that the additional currency risk was not factored into the credit rating and, secondly, the timeline of events suggested that the constant revision of estimated LCCP costs, the size of the project relative to the company, and the ineffective communication channels between management and executives were clear signs that governance risk was not correctly priced into the debt instrument. As such, Sentio preferred not to invest in the instrument until it fully reflected the underlying risks. Subsequently, the instrument was re-rated with a wider credit spread.

Sentio’s unique approach thus offers clients far more than a matrix of ‘good to haves’ and dives deep into the core of the organisation to determine the key drivers and culture that determine the true interface between risk and value.