How Top-Down Governance Analysis Adds Value
Top-Down VS. Bottom Up
Overwhelmingly, investment professionals today utilize an investment process generally known as “bottom-up” investing. A typical bottom-up investor emphasizes equity selection and researches an assortment of companies, attempting to pick those with the greatest likelihood of outperforming the market based on individual merits. The investor mixes the selected securities together to form a portfolio; however, country and sector exposures are often simply residuals of security selection.
“Top-down” investing reverses this process. A top-down investor first analyses such macro factors as economics, politics and sentiment to forecast which investment categories are most likely to outperform the market. Only then does a top-down investor begin looking at individual securities. Top-down investing is inevitably more concerned with a portfolio’s exposure to broad investment categories than any individual security. Thus, top-down is an inherently dynamic mode of investing because investment strategies are based upon the prevailing market and economic environments (which change often).
Top-Down in an ESG Framework
Top-down research is highly complementary to ESG analysis. In a world of global supply chains and multinational corporations, implementing ESG considerations in the investment approach requires global insights. Over 48% of revenue of MSCI World constituents and 30% of revenue of MSCI EM constituents is derived from abroad.
Top-down investment management is all about considering factors (risks and opportunities) outside the scope of traditional financial statement analysis. This is also the main goal of ESG integration.
For example, understanding the political/legislative/corporate norms of a country can help avoid environmental or regulatory risks securities in any given country may be exposed to. To summarize: Good top-down decisions already demand ESG considerations.
While ESG factors are of significant importance, in this article, we will focus exclusively on the added value of analysing governance considerations through a top-down lens.
The Pitfalls of Quantitative Governance Screening
One common approach in ‘best in class’ ESG strategies is for managers to quantitatively screen out low-rated companies by total score or by individual pillar scores (E,S,G). While applying a common risk framework (ESG score screening) may be appropriate for environmental and social considerations, it is inappropriate for governance review.
No Shortcuts to Security Level Governance Analysis
Broad common externalities (e.g. carbon regulation, consumer preferences) primarily drive environmental and social risk. A common risk framework (ESG score screening) thus may reasonably help managers assess security-level environmental/social risks. However, while key governance-related externalities need to be considered (e.g. government influence, country reforms), internalities unique to an individual company’s structure, management team and business/industry primarily drive security-level governance risks. In analysing governance risks, therefore, a common risk framework like ESG score screening may not sufficiently help managers.
Corporate Governance Analysis Integration
Instead of applying a one-size-fits-all common framework for governance analysis, Fisher Investments evaluates governance factors at multiple stages throughout the investment process. It does this at both the top-down level (with Capital Markets Analysts and the Investment Policy Committee developing country, sector and thematic preferences) and at the bottom-up/security-level (with Securities Analysts conducting fundamental analysis and engagements.)
Top-Down Governance Process & Examples
In a top-down investment process, sector, country, style and thematic decisions contribute materially to relative performance. As such, identifying factors likely to contribute positively or negatively to country/sector performance requires significant effort. At the country level, for example, governance analysis primarily includes the degree to which a country’s political/regulatory structure and trends (e.g. reforms) may influence business results or investor preference for that country relative to alternatives. Top-down governance factors considered when determining country and sector/industry allocation include governmental influence on public companies, regulation, social policy, and market reforms impacting private property, labour or corruption.
Bottom-Up Governance Process
FI’s Securities Analysts perform fundamental research on prospective investments to identify securities with strategic attributes most consistent with the firm’s top-down views and with competitive advantages relative to their defined peer group. Governance analysis at the security level involves assessing a company’s risks (e.g. ownership concentration, share class structure, proxy fights) and its ability to mitigate such risks (e.g. through board structure, independent auditor activities or managerial quality assessment). When security-level concerns present an inordinate risk to a company’s operational or financial performance, or the firm believes they present undue headline risk to share price performance, FI would choose not to invest in that company.
Engagement and proxy voting are also important parts of FI’s governance analysis. FI engages with companies as part of its fundamental analysis and to clarify or express concerns over potential governance issues. FI also interacts with company management on proxy voting issues, particularly when our proxy voting services provider, Institutional Shareholder Services, Inc. (ISS), disagrees with company management. FI’s broader Engagement Policy is available upon request.
The importance of independent and detailed governance analysis cannot be overstated.
As discussed, there are no shortcuts to governance risk assessment, as internalities unique to an individual company’s structure, management team and business/industry primarily drive security-level risks.
Using a quantitative screening approach relying on third-party (e.g. MSCI ESG Research, Sustainalytics, ISS, etc.) could lead to individual missed opportunities or a restriction of large swaths of the investment universe, such as Chinese ADRs using the Variable Interest Entity (VIE) structure.
Corporate corruption concerns are most often focused on scandals (e.g. Operation Car Wash in Brazil) that have caused passive ESG investors to persistently underweight entire countries. Such simple risk-avoidance strategies lead investors to miss out on alpha opportunities that top-down macro managers such as FI don’t overlook.
A strategy that simply screens out lower-rated companies could likely exclude an entire country or create a chronic underweight position to areas like Brazil, one of the nations with the worst Bribery and Corruption scores (per MSCI ESG Research). As a top-down manager, Fisher Investments acknowledges the risks in Brazil but also balances them with the alpha opportunity depressed stock sentiment and fundamental economic tailwinds bring.
Furthermore, by simplistically avoiding Brazil due to fears of corporate corruption, investors also overlook the positive impact produced through the Brazilian banking system. Brazilian banks have a history of lending to low and middle class individuals, helping drive increased credit penetration for the country.
Companies such as Banco Bradesco have used unique approaches, such as riverboats, in order to bring banking to underserved regions of the country. Such investments support UN Sustainable Development Goal #1—“No Poverty”. One way for investors to reduce poverty is through investment in banks that provide credit to underserved communities. Investing in Brazilian banks—despite corruption fears—can help achieve that aim.
This article appears in the Fisher Investments ESG Perspectives Newsletter.