Five Questions about SRI – Weekly Expert Interview with Alvar Roosimaa, Fund Manager, Limestone New Europe Socially Responsible Fund, Tallinn, Estonia – November 19, 2010

Each week Emerging Markets ESG publishes an interview entitled, “Five Questions about SRI.”  The interview features a practitioner’s insights about SRI in emerging markets and through Emerging Markets ESG shares this expertise with a wide global audience.  The goals of Five Questions about SRI are fourfold:

  • To reflect on what SRI in emerging markets means to practitioners;
  • To collect a catalogue of examples of SRI in practice in emerging markets;
  • To raise awareness about SRI in emerging markets; and
  • To enable SRI practitioners in emerging markets to network with peers around the world.

This week’s interview is with Alvar Roosimaa, Fund Manager, Limestone, a specialist Emerging European equity fund manager based in Tallinn, Estonia.

Founded in 2007 and majority owned by its managers, Limestone is one of the very first New Europe based investment managers that integrates the concepts of socially responsible investment (SRI) and sustainable development into fundamental research process as essential factors for long term performance and risk management. Limestone New Europe Socially Responsible Fund is a Luxembourg domiciled long-only equity fund that invests in Central and Eastern European companies that offer good opportunities for capital appreciation and meet the Fund’s investment and social criteria. A bottom-up fundamental research driven investment process is applied to construct an actively managed high conviction portfolio. Portfolio companies are expected to comply or to actively pursue compliance with international norms on Environmental, Social and Governance (ESG) issues in accordance with the UN Principles for Responsible Investment. The Fund’s SRI approach is best characterized as ESG factor integration and active engagement with minimal negative screening.

Emerging Markets ESG:  How would you define socially responsible investment (SRI)?

Alvar Roosimaa:  Very broadly, investing socially-responsibly means for me and our fund that the companies that we invest in have their interests aligned with the surrounding society. This consists of various layers of activities and responsibilities, kind of like a Maslow pyramid of SRI. As a prerequisite, our investment objects’ business activities cannot be directly harmful for the society; smoking, gambling, firearms and alcohol quite obviously are harmful for the wider good. Then there are companies that have everything in place to be a responsible social citizen, and are already acting accordingly; this is the top of the pyramid. And there are the ones that could be socially responsible but have not recognized it yet, and need a push. The latter category is where our approach of engagement makes the biggest difference.

Emerging Markets ESG:  What distinguishes SRI from mainstream investment?

Alvar Roosimaa:  Sadly, it is almost a paradigm that money invested responsibly has inferior performance. The main problem, as we see it, is the often found detachment of fundamental analysis and active portfolio management from the investment process and replacing it with backward looking ratings. For us, the difference comes from adding factors to the traditional valuation and investment process, not eliminating or replacing tasks. We ask more questions from our investee companies than a typical investor who is only concerned about financial outlook for the next quarters. And we transform the answers we get into data that affects fundamental valuation. This is very important: company’s past or current ESG achievements are not what we invest in (as is the case with rating based best-in-class funds) but these change company’s long term financial value.

Emerging Markets ESG:  Which extra-financial theme – environmental, social or governance – is the most challenging for companies in Eastern Europe to manage?

Alvar Roosimaa:  There is a natural order for things to happen. Without proper governance, environmental and social behavior of the company can hardly improve. You have to clean your own house before you can go and do bigger things around you. What we have seen is that companies that have recognized the need to improve their governance standards, disclosure and transparency, are usually moved on to work on their environmental and social agendas.

Emerging Markets ESG:  Which extra-financial theme – environmental, social or governance – is the most challenging for investors in Eastern Europe to analyze?

Alvar Roosimaa:  As said in the previous answer, the E, S and G usually come in a package. If one is completely missing the two others cannot be very sustainable either. Hence, it all boils down to disclosure and transparency, the prerequisites for a good corporate citizen.

Emerging Markets ESG:  How does Limestone integrate ESG factors into the portfolio selection process for the New Europe Socially Responsible Fund?

Alvar Roosimaa:  Integration of ESG factors to fundamentals has had various approaches over the years. There are numerous studies carried out on how the corporate responsibility affects market value, what are the key performance characteristics, and who can benefit most from it, yet quantitative application has so far been rare. Early on it was clear for us that a new approach to address the issue was needed. As our fundamental valuation models utilize cost of equity based on country specific risk free rates with unified risk premium and industry-specific beta factors, adjusted by liquidity and leverage premiums, we took cost of equity as the main factor to be adjusted by ESG factors. To include the assessment of the ESG factors to the above cost of equity calculation, we introduced an ESG matrix, where our analysts rate each company by these three factors that together create an overall ESG score of the company.  To make the building blocks simple, we introduced a rating score from 1-5, where the score of 3 will not ignite any changes to the cost of equity and each notch below or above adds or subtracts, respectively, basis points from cost of equity.

Clearly, the scale of justified adjustment to cost of equity is debatable. From our calculations we regard the selected 20 bps per grade to be just about sufficient. We want the integration tool to bring relevance to valuation process but avoid the situation where ESG factors dominate the fundamental valuation. According to the selected scale of adjustment, the cost of equity can vary by 240 bps on scores from one to five.  Given that the average cost of equity is 12%, the gap between best and worst ranking companies will be 9.6-14.4%, or about a third, which is obviously quite significant range that will have strong impact on estimated company value.