How Itaú Asset Management Is Driving Integration of ESG Criteria into Fundamental Equity Valuation

Is the investor community of the world’s most advanced economies informed, engaged and excited enough to make significant progress on building sustainable investment portfolios? How likely is that and how could it be done?

The answers remain largely unclear, if not leaning more toward a “no” than anything else. At the same time, some forward-looking leaders in financial services are taking specific practical steps in their pursuit of tangible solutions that could be implemented immediately. Consider the case of Itaú Asset Management[i] (IAM). 

Several months ago, IAM released a white paper outlining its new Responsibility Investment practices with a focus on sharing how it has integrated Environmental, Social and Governance (ESG) issues into its fundamental equity valuation models, asset allocation, and selection and ownership practices. It is an approach that allows IAM to achieve its fiduciary duties and create value for its customers by providing better returns for certain given risk profiles. With its ESG integration method, IAM has essentially achieved higher accuracy in the analysis of publically listed Brazilian companies.

Itaú Asset Management's
Denise Mills
will discuss
sustainable investment portfolios
at
New Metrics '14

IAM developed ESG integration because 1) sustainability funds can generate higher risk-adjusted returns (alpha), as has been corroborated by a growing body of academic and practitioner research, and 2) there has been a growing market interest to develop more sophisticated techniques for ESG integration that go beyond offering funds with explicit ESG criteria and that develop rigorous analytical tools. IAM has created a more sophisticated technique by modeling the impact on companies’ cash flows and cost of capital as a result of ESG integration with fundamental equity valuation. IAM’s ESG integration method helps to anticipate risks and opportunities before they materialize in stock prices, as ESG risks can materialize abruptly and unexpectedly through extreme events, policy developments, and government actions. For example, although employee-relations indicators go unnoticed by the market, monitoring such indicators helps to anticipate changes in workforce productivity, the occurrence of strikes, and the creation of liabilities that will affect margins quarter after quarter.

The objective of IAM’s ESG integration method is to adjust individual target stock prices and to anticipate events that result in value creation or destruction, providing flexibility to portfolio managers who use ESG valuation inputs to varying degrees. IAM’s ESG integration method incorporates a three-stage process outlined below.  

ESG integration method: ESG research, quantification, and valuation

1. ESG Research:

During the research stage, ESG data and information relating to the different sectors and companies covered is collected and structured in 3 steps:

Step A: Cross-sectoral dimensions

IAM has identified and clustered eight cross-sectoral dimensions, which are broken down into environmental and social dimensions and which are ranked according to their relevance for specific sectors. Cross-sectoral dimensions provide a way to detect and capture sector and company specific ESG information, with a focus given to the most material issues for each sector.

Step B: Sector specific value drivers

Cross-sectoral dimensions are adjusted into specific value drivers for each sector, which includes identifying risks and opportunities, creating metrics, and understanding time horizons and potential game-changing events and policies.

Step C: Company exposure and performance

Through annual and sustainability reports, regulatory filings and other official company communication as well as company visits and stakeholder consultations, IAM analyzes the exposure of each company to its material ESG dimensions and how the company performs and manages these issues.

2. Quantification:

Qualitative and physical research collected during the research stage is transformed into quantitative material for valuation. Following a quantification process, IAM analysts have the necessary variables to include ESG issues into projected cash flows and cost of capital as well as having appropriate data to conduct stress tests and sensitivity analyses.

3. Valuation:

In this final stage, IAM analysts integrate quantified ESG issues into its valuation models using the Discounted Cash Flow (DCF) method. This makes it possible to find the Net Present Value (NPV) of ESG issues and highlight and compare the impact of ESG value drivers across companies of the same sector.