You don't need to give up gains to pursue an ESG strategy in the stock market

By Philip van Doorn

Brian Burrell of Thornburg explains how combined ESG and financial analysis can identify companies whose improved profitability is directly tied to their efforts to make the world a better place

When investors are told that "ESG" is part of a fund manager's strategy, they might expect to give up some potential gains while focusing on companies making efforts to comply with a set of standards for environmental, social or corporate governance factors.

Some large money managers have ESG departments that do their own analysis, separate from the traditional financial analysis by fund managers selecting stocks. But rather than using ESG analysis to exclude companies from consideration, an integrated analysis can identify companies whose positive ESG efforts "meaningfully impact the bottom line," according to Brian Burrell, a portfolio manager at Thornburg Investment Management.

Thornburg is based in Santa Fe, N.M., and manages about $44 billion in client money through mutual funds and various strategies for individuals and institutions.

Burrell co-manages the Thornburg Better World International Fund TBWIX, along with Lei Wang and Joe Salmond. The fund is rated four stars (out of five) within Morningstar's "Foreign Large Blend" category. For five years through Tuesday, the fund's average annual total return of 10.8% (after expenses) has placed it in the second percentile of 619 funds in its Morningstar category. The category's five-year average return has been 6.3%, while the MSCI All Countries ex-U. S. Index (in U.S. dollars) has had an average return of 6.4%, according to FactSet.

In Japan, there are often hidden gems buried within a conglomerate's construction. The key reforms in Japan have essentially been accountability, simplification and clear communication.Brian Burrell, portfolio manager at Thornburg Investment Management.

During an interview with MarketWatch, Burrell said ESG was fully integrated into bottom-up stock analysis at Thornburg. He was formally named as a manager of the Better World International Fund in January, but had been involved with the fund's investment selection process as an analyst since it was launched on Sept. 30, 2015.

How ESG-related improvements can increase profits

An example of a company selected for the Fund through the integration of ESG and fundamental analysis is Nissin Foods Holdings Co. (JP:2897), which makes Cup Noodles and many other food products.

One obvious way for Nissin to improve the ESG aspects of its management has been its movement away from styrofoam packaging.

"The predominant packing the company now uses is recycled paper," Burrell said.

He said Nissin had invented the instant-noodles food category in Japan after the end of World War II. Recently it has been "premiumizing" its brands, he said. This includes the addition of more dehydrated vegetables to its various noodle products.

"Think about the headroom - just carbs selling for 50 cents or so, up to a nutritious tasty meal for a couple of dollars - that is a four-times price increase," he said, "but still at a lower price than alternative meals."

Japanese companies are giving up old habits

Over the past couple of years, there has been wide coverage in the financial media of what has appeared to be an awakening for publicly traded Japanese companies. One important factor has been a push by the Tokyo Stock Exchange for companies to improve their capital allocation and efficiency.

"Corporate Japan has discovered corporate governance," Burrell said, not only because of the new guidelines from the Tokyo Stock Exchange, but because of "external pressure from investors."

One example of a company held by the fund that has been working to improve its return on invested capital by shedding less-profitable business unites is Mitsubishi Electric Corp. (JP:6503). Burrell said that back in the 1980s, the Los Angeles Dodgers had added giant LCD screens in their stadium, which were made by Mitsubishi Electric.

The company was a pioneer of a technology that eventually was so widely adopted that it became a low-margin commodity. So Mitsubishi Electric stopped making LCD equipment.

This is emblematic of the theme in Japan, of companies that have proud histories changing their ways by "de-emphasizing or divesting underperforming businesses and refocusing on where they have competitive advantages," Burrell said.

For Mitsubishi Electric, business units that are performing well programmable logic controllers (PLC) and computer numerical control (CNC) equipment. "These are both factory automation products. It is an area where Mitsubishi Electric dominates in Japan and has a strong presence outside of Japan," he said.

"In Japan, there are often hidden gems buried within a conglomerate's construction. The key reforms in Japan have essentially been accountability, simplification and clear communication," Burrell said.

He added that Mitsubishi Electric's automotive unit is "up for sale," and that another growth area is supplying Japan's defense industry. Japan's government passed legislation last year to make it easier for the country's defense contractors to export to other companies, while also helping them improve their profit margins.

When asked which financial analysis items he and colleagues were focusing on to ensure overall quality, Burrell said: "The two guiding lights for us are financial leverage and free cash flow generation. A conglomerate structure can hide a lot, but at the end of the day, money in the bank is hard to fake."

Top holdings of the fund

In addition to the two Japanese companies that Burrell discussed, he mentioned Schneider Electric SE (FR:SU), which is based in France and is well positioned to participate in the build-out of computing infrastructure to support generative artificial intelligence technology. He called the company "a leading global supplier for low and medium-voltage equipment - the electrical guts of buildings and data centers."

These were the largest 10 equity holdings (out of 56) of the Thornburg Better World International Fund as of May 31:

   DK:NOVO. B                                 Ticker   Country        % of fund 
   Hitachi Ltd.                               JP:6501  Japan               3.3% 
   Constellation Software Inc.                CA:CSU   Canada              3.1% 
   L'Oreal S.A.                                FR:OR   France              3.1% 
   Canadian Pacific Kansas City Ltd.           CA:CP   Canada              3.0% 
   Schneider Electric SE                       FR:SU   France              2.9% 
   Mitsubishi UFJ Financial Group Inc.        JP:8306  Japan               2.8% 
   Sony Group Corp.                           JP:6758  Japan               2.7% 
   BNP Paribas S.A. Class A                   FR:BNP   France              2.7% 
   Samsung Electronics Co. Ltd.              KR:005930 South Korea         2.6% 
   Novo Nordisk A/S Class B                  DK:NOVO.B Denmark             2.6% 
                                        Source: Thornburg Investment Management 

Click the tickers for more about each company.

Read: Tomi Kilgore's guide to the wealth of information available for free on the MarketWatch quote page.

The table shows where each of the top holdings is domiciled, however, Burrell stressed that many of the companies held by the fund derive a majority of their revenues in other countries. Looking at the fund's May 31 breakdown, the fund was 21.6% concentrated among Japanese companies, with France ranked second at 17.3% and the U.S. third at 15.1%.

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-Philip van Doorn

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