ESG vital part of special sits recovery stories

The drive towards a genuinely sustainable economy means most investors view environmental, social and governance (ESG) considerations as a “must have”.

As a result, the world’s most highly valued companies have clear and compelling ESG agendas. It follows that ESG must be central to the recovery of any business that has fallen out of favour with the wider investment community.

This is certainly the case in the arena of special situations, which focuses on companies whose particular circumstances have brought depressed valuations and investor indifference. In spite of their short-term difficulties, many of these organisations can present attractive opportunities over the longer term.

The key to a successful turnaround frequently lies in the appointment of a new management team with a clear vision of the way ahead. More so now than ever before, ESG is likely to be a major part of that vision – and a vital element of the progression from rehabilitation to revitalisation.

Environment: putting the planet first

Climate change and the journey to net zero ensure the E of ESG is uppermost in the thinking of many companies and their investors. Scientific reality, popular sentiment and legislative pressure all lend themselves to the cause.

Many companies should benefit from a commitment to a green economy. Take FirstGroup (one of our holdings) which operates transport services across the UK.

Earlier this year the company announced it would spend an additional £35 million to accelerate the rollout of electric buses, of which it hopes to have more than 600 running by March 2024. Government funding has already been secured to help meet this target.

As part of the move, FirstGroup’s bus depots in York and Norwich are set to become the first outside London to have fully electric fleets. CEO Graham Sutherland has described the ongoing transformation as “another important step” in the business’s decarbonisation efforts.

Social: stakeholder capitalism in action

S has long played third fiddle in the ESG trio, but this is finally changing. How a business relates to its stakeholders – both internal and external – is now gaining much more attention. Another of our holdings has offered a great illustration of this shift during the past few years.

Low-cost airline Jet2 started to set itself apart from its peers during the COVID-19 crisis, when its treatment of staff and customers was exemplary. In response to curbs on travel, management introduced a rapid refund policy for passengers. Most employees were retained – despite the tourism sector’s collapse – meaning the company was among the first airlines to get back up to speed when restrictions were lifted.

This determination to “do the right thing” has persisted in the pandemic’s wake. Jet2 has maintained a strong presence at check-in desks, kept flight cancellations to an absolute minimum and upped wages by 9% to help workers keep pace with inflation and the cost of living.

Little wonder that the business has won a number of prestigious awards, including being named Which?’s Travel Brand of the Year in both 2022 and 2023. Going forward, stakeholder satisfaction should increasingly translate into shareholder satisfaction.

Governance: moving beyond a tick-box culture

The G of ESG refers to issues such as high-level decision-making, transparency, accountability, diversity and conflicts of interest. It may sound relatively dull and bureaucratic, but in many ways it is the bedrock of ESG in its entirety.

Greater scrutiny of governance standards sometimes leads to a tick-box, big-business culture. This can satisfy the large ESG rating agencies, but it may change little on the ground. No company has ever discovered the secret of success is to have more committees.

Some of our most successful and longstanding investments have been in owner-managed businesses, such as Computacenter, where managements’ large personal shareholdings align their interests with our own. This encourages long-term strategy implementation rather than a focus on stretching near-term financials to hit a short-term bonus target.

Rating agencies may flag concerns about board independence, but we value the decades of experience that founders can bring to the table. By concentrating on culture, meeting different management layers and understanding long-term strategy, we can gain greater insight into a business than a one-dimensional box-ticking review.

Synergies and dual objectives

As the managers of a special situations fund, we look for businesses that are unloved and undervalued. They are usually unloved because of events that impact their short-term prospects. They are usually undervalued because most investors do not recognise their capacity to improve over time.

As a company fulfils its latent potential and transitions from rehabilitation to recovery to revitalisation – the three Rs of special situations investing – we expect to see better margins. In tandem, we also expect to see better ESG policies, practices and scores.

It might be argued that it is now impossible to have one without the other. As FirstGroup has said, capital expenditure should “benefit all stakeholders”. As Jet2 has stressed, efficiency is directly linked to “the right thing to do”. As Computacenter has observed, a business should strive to be one that “our people, customers, partners and communities can be proud of”.

The synergies are obvious, and they underscore the bottom line – literally and figuratively – that ESG matters. This is the case both for companies that are already at the top and, just as importantly, those that are on their way back.

Derek Stuart, Andy Gray and Henry Flockhart co-manage the Artemis UK Special Situations Fund.