People power: finding alpha from the S in ESG

Viewpoint

• In addition to environmental and governance considerations, we believe social factors, and in particular human capital management, are important indicators of management quality and long-term performance.
• Particularly during ‘AGM season’ we pay close attention to social themes such as safety and employee engagement, knowing they flow through to employee wellbeing, productivity – and profitability.
• The social component of our integrated approach to ESG across each of our investment strategies provides a clear focus on how a company cares for and engages its people – and we believe is a key input to sound investment decision-making.

Our approach

With the Australian Annual General Meeting (AGM) season in full swing and investors poring over companies’ remuneration reports and director nominations, it’s an opportune time to delve a little deeper into the ‘S’ in ESG – that is, the social factors that go with environmental and governance factors in ESG investing.

While often overshadowed by the urgency of a climate debate or the more intrinsic corporate governance fundamentals, we also look at the way a company manages its social risks as an important lead indicator of management quality and long-term performance.

Human capital management, in particular, is an important indicator to focus on because of its double materiality: In our view, better management of employee outcomes provides real world benefits for impacted people and may also have financial benefits for companies. On the flipside, when companies get it wrong the impacts can be severe.

As an example, safety performance is a critical facet to manage. Incidents can trigger project and production delays and, ultimately, lower operating performance. Our own analysis over the last year has shown declines in health and safety metrics in Australian companies, hampered by high turnover rates and talent shortage. With safety accounting for an average 20% of large-cap resources companies’ short-term incentives¹, it is also closely tied to executive remuneration. We expect this AGM season will see institutional investors vote against company remuneration reports and director nominations in direct response to poor safety performance that has tragically resulted in worker fatalities.

The importance of engaged employees

Another key signal of corporate performance is employee engagement. Intuitively we know companies with more engaged workforces will have higher productivity and be better placed to track and retain talent, and this is increasingly backed up by research. According to a report released earlier this year², the stock price of companies with high employee engagement performed twice as well as companies with low engagement scores. Spanning more than three million employees across 226 large listed global companies, the research found each additional point of employee engagement was valued at over US$46,500 in market cap difference per employee. Another report by Deloitte found companies with highly engaged employees experience three-year revenue growth rate 2.3 times greater than average³.

Parting thought

With the social component with our ESG framework providing both humanistic and financial signals, we believe a clear focus on how a company cares for and engages its people is a key input to sound investment decisions.

1  Macquarie Equity Research, Australian ESG Equity Strategy People Power – 2023 HCM Indicators, June 2023
2  Microsoft, The New Performance Equation in the Age of AI
3  Deloitte Employee Engagement Perspectives, Engaging the workforce

Disclaimer
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The breakdown of the sector returns over both 2023 and 2024 highlights that 2024 was a year for momentum investors: sectors / stocks that did well in 2023 generally continued to do well in 2024 and visa versa.

A few extreme examples of the “haves” at a stock level include Seven Group (up ~ 80% in 2023 and a further ~ 30% in 2024), Pro Medicus (~ 70% in 2023 and then a remarkable > 160% in 2024), REA (~ 65% and then 30%), Xero (~60% and 50%) and Life360 (55% and a chart topping ~ 200%!).

The other unusual factor at play during 2024 was that returns were generally driven by a price earnings (PE) multiple rerating rather than earnings growth. The chart below highlights this.

Index returns from start of 2024