Replay - ESG Isn't What You Think It Is
Published on November 3, 2022
Venk Reddy, CIO of Sustainable Credit, and Marcus Moore, Assistant Portfolio Manager, provided a behind-the-scenes look at how sustainability factors impact creditworthiness and how you, as a fixed income investor, can make a difference with your capital.
Paige Uher: Hello. Thank you for joining us today on our webinar. My name is Paige Uher, and I'm a member of the Osterweis Business Development team. Venk and I were the owners of an independent investment advisor launched in 2009 where we were dedicated to sustainable credit strategies. We've known Osterweis since we launched our firm. And as of May 1st, we are proud to say of this year, our team joined the Osterweis family.
With me today is Venk Reddy and Marcus Moore. Venk has managed the Sustainable Short Duration Credit strategy since 2009 and launched the mutual fund version in 2011. In 2019, we launched a complementary Sustainable Credit Strategy that was similar in the approach, but we just lifted the duration constraint. Today, you're going to hear from the two portfolio managers of the Osterweis Short Duration Credit Fund and Osterweis Sustainable Credit Fund, tickers ZEOIX and ZSRIX, and how we integrate ESG factors into our process. And you might just be surprised that ESG isn't what you think it is, hence the name of the webinar. If you have questions along the way, please enter them into the Q & A section, and we'll answer them throughout the presentation or at the end with time permitting. And with that, I would like to introduce you to Venk Reddy, Chief Investment Officer of Sustainable Credit at Osterweis and Marcus Moore, Assistant Portfolio Manager. Thank you both for being here.
Marcus Moore: Thank you.
Venk Reddy: Thanks Paige, and thanks everybody for joining us. We really appreciate you taking the time out of your day to hear what we have to say. We've been managing sustainable credit portfolios for quite a while. And I think as we go through, as we hear from folks, as we understand what is an area that people want to learn a little bit more about, I think we really kind of have drilled down on some key questions of sustainable investing. These are the things that we get in one form or another people ask us all the time. So we're going to try to answer those for you today.
Number one, what does it mean? There's a saying that if you've met one approached ESG, you've met one approach to ESG, so we're really going to try to drill into that a little bit. Number two, how is it done? Where does it fit in portfolios and for various investors? And then who can you trust? So before we get started, I do want to take a survey here just to get a sense of who's in the room, get the temperature of our Zoom room here. So we have a little question for you all, if you don't mind answering it, and then we'll see the results in a second. Oh wait, hosts and panelists can't vote? How am I going to... Oh, that's a bummer. All right. So we-
Paige Uher: Results are coming in, Venk.
Venk Reddy: Great, great. So while we are waiting for the results to come in, I mean one thing I do want to make clear is, like I said, there's a lot of different approaches to integrating ESG factors into investment strategies. So we're going to spend less time telling you necessarily what it means to us, and we're going to focus more on telling you where ESG came from in the first place. Because I think we've got our poll results here and we have a handful of folks that are probably on the skeptical end. A quarter of our folks are somewhere between indifferent and skeptical and the balance are rather warm to the idea. I think a history lesson helps us kind of level set of where we are, where ESG is, what ESG is. So with that, I think we're going to dive into, what does it mean?
So we're going to start with the history of the term. So the term ESG was primarily popularized in a publication in 2004, written at the behest of the United Nations by the joint initiative of financial institutions. The name of the publication, if you want to look it up, and I'm sure we can follow up on this webinar with a link to it as well, was called Who Cares, Wins, not Who Cares, Who Wins but "Who Cares, Wins." And what's really interesting there is this group was initially designated for the purpose of really identifying the integration of environmental, social, governance factors in investing. Fun little fact, they thought governance was most important, but they didn't like the acronym GES. Then they thought about EGS but felt like social was still important but it was going to get lopped off the end because it was easier to say E and G.
So then they decided on ESG and that's how we ended up with ESG, because they didn't want to lose the S and they didn't like acronyms that started with a G. So I don't know if anybody cares about that history, I think it's kind of fun. But it was followed up the very next year with what I think is probably the more important publication for sort of the future of investing using ESG factors, which was a commission by the United Nations to a law firm called Freshfields, where they wrote 151-page document defending the legal justification for fiduciaries to include ESG factors in their investment processes and decisions. This is really interesting not just because in 2005, they had this very long legal justification or knew the need for it, but that we're still having this debate today, 17 years later, as to whether there is a justification for fiduciaries to include ESG factors in their investment decisions.
And the key observations across all of - both of these documents and some of the research has happened in this area is number one, there was a very clear focus on financial materiality of ESG issues. So from the very beginning, including firms that have been around in responsible and sustainable and impact investing for a very long time, certainly before 2004, there was a clear view toward this focus on the factors that have a true material financial impact on the company that one is considering. Number two, there was an extremely clear observation that timeframes matter. When it comes to risks associated with environmental, social, or governance factors, the timeframe over which you're investing, whether you're investing in a short timeframe like a one-month or three-month timeframe, or if you're investing for a 5- or 10-year timeframe, results in a materially different exposure to that risk.
And if you're investing for the long term, you're going to consider certain risks differently than if you're investing for the short term. And that actually is something that is particularly important. The law firm, Freshfields, actually highlighted this is a really important characteristic in determining the fiduciary obligations and how ESG factors work into that. We're going to talk about this a little bit more in detail later on in the presentation. And then the last piece is that there was a very clear call for transparency and disclosure. We know right now that regulators certainly here in the United States do not mandate objective disclosures around ESG factors.
The SEC is currently exploring how they can do this. Most companies print, not most, a lot of companies print glossy little brochures talking about the things they want to talk about. So those are subjective disclosure, but we don't have objective disclosure. But this transparency and disclosure, which was identified as a need 17 years ago and today is still, I would say, I don't know, maybe we're 17 years away from it. I don't really know how far we are away from it, but we're not close enough to where we need to be. And this actually factors into some of the stuff we're going to talk about later too.
But these items are what really defined the kind of the origin of this term and this effort in sustainable investing. And before ESG, we actually had this notion of sustainability. So back in 1987 in a document called Our Common Future, the United Nations had a commission that wrote a report about sustainable development. You can read it on the screen. I'll read it out loud because I think it's worth hearing. "Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs." So if we really think about what sustainability means in general, and this was about economic development, not about investing, but we are investors and we are investors that believe that sustainability and companies that behave in ways that similarly don't compromise the present, it's not compromise the future in the service of the present is super important when you're investing with considering risk, especially if you're investing for the long term.
So we actually adapted this definition to really speak to sustainable investing and particularly sustainable value investing, sustainable fundamental investing as, and I'll read this out loud again, especially since it's our quote now, "Sustainable business practices are practices that enable management teams to meet the needs of current stakeholders without compromising the ability of future management teams to meet their own stakeholders' needs." So the reason this is important is look, colloquially speaking and apologies for the slightly crude metaphor, but we're just basically saying, look, current management teams shouldn't leave little turds for future management teams to clean up. And this isn't a performance thing, right? That they don't do this because this quarter or this year, this CEO is going to get credit for this success at this company. What we're really talking about, it's a long term risk thing.
Our view especially, look, what we do in the Osterweis sustainable credit team is focus on credit investing, so we really focus on credit worthiness. So when we think about what the notion of sustainability means to credit, it essentially means we want a company to be creditworthy in 10 years. And that requires today's management teams to be thinking about long term risks, not just short term risks. That's true, whether it's a risk that falls under the ESG category or whether it's a risk that falls outside the ESG categories, and that materiality is key. The factors that actually materially impact that business are where we focus in based on this original definition and thought process around the term ESG. But we're really holding management teams today accountable for mitigating future risks, not just for targeting current successes. So if we bring it all together, what we're really saying is sustainability is a long term risk management concept, not a short term performance concept.
That's a really important realization is that it is a long term risk management concept. ESG is a collection of risks. And that's sort of where we get to this notion that if you are going to be long term sustainable as a company, you want to be considering as many risks as you can possibly consider. There's no reason to say, "Hey, you know what? I guess this little group of risks, I don't want you to think about them. Don't even think about them even if they impact your business, ignore them for now." That's not how you build a business that's going to be here in 20 years or 30 years or 10 years even in some cases. So you're really focused on having as many potential scenarios as you can possibly have to consider, so that you know that decisions you make today aren't going to surprisingly put people, whether it's future management teams, future investors, future stakeholders, in a compromised position in the future.
That brings us to ESG. ESG is not a strategy, it is not an adjective. And I will make this mistake during this presentation I'm sure, referring to things as an ESG strategy or an ESG this or an ESG that. It's not an adjective. It's simply an acronym for three categories of risk that are not new. I mean, Marcus likes to routinely bring up that Exxon Valdez happened long before ESG was a household term in the lexicon of most investors. These are not new risks. Governance risks are not new. The risk of stakeholders compromising your business because of some social policy of a company, it's not new. It happens that we're categorizing these risks in a way that's actually constructive in allowing investors to be aware of the risks they're taking, and we've still got a long ways to go, but it is just a set of risk factors.
And so when we think about sustainable value investing, which we'll talk a little bit about where that fits into the broader ESG landscape later, but talking specifically about this not code notion of sustainable value and sustainable investing, what we're really saying is that we are evaluating the issuer's exposure to these risk factors that are material to their business over time. I cannot tell you that this risk is going to manifest itself today or this quarter or this month. And in reality, look, I mean I've been known to say this a lot, just because a risk doesn't manifest itself, doesn't mean it didn't exist. So there are a lot of irresponsible ways to make money and there are a lot of markets in which people can make money, taking a risk that they probably shouldn't have taken or probably got lucky. The goal in an investment portfolio is not to get lucky, it's to actually make informed educated risk decisions.
So thinking about risks over time and not really just focusing on the risks that are going to happen in the next month or next quarter or next year is particularly important. And then what's really important about this is these risks, the way we talk about and the way most analysts who evaluate ESG risks think about, I think, think about. I don't know what most analysts, I know two here, but we at least treat these risks the way we treat other risks. It's consistent. This notion of looking at a risk and evaluating how it's going to impact creditworthiness is true, whether it is leverage as a risk, or whether it is a governance challenge as a risk. So this approach to sustainable value is consistent with how analysts, fundamental analysts should evaluate all risk factors, ESG or not.
And again, we'll get there and we're going to go into that next with our talking a little bit about how this is done. But before we get into specifics of ESG fundamental analysis and fundamental investing, I wanted to paint a bigger picture of the landscape of ESG strategies. So most people, when we think about ESG strategies that incorporate ESG factors, see there, I go using ESG as an adjective again, strategies that incorporate ESG factors, we think in this terms of good and bad. So we think in this term of there are folks who are proactively selecting good guys and then there are folks that are, and those would, I guess the term would be activists, and then there are folks that are proactively throwing out bad guys, and those would be the negative screeners. This is kind of the dichotomy of the sustainable investing kind of world, but it's a false choice to a large extent.
It's really predicated on the convenience of having ratings. If I can tell you someone is good or bad, then I can throw out the good guy, I can pick the good guys or throw out the bad guys. And you end up with either this sort of research-driven approach or this radio-driven approach, this proactive selection and this negative screening. But with the help of some friends at the Wharton School, who we've talked to quite a bit and collaborated with in the past, they have this group called ESG Analytics Lab. And they actually did statistical analysis, they used equity ESG-oriented portfolio mutual funds and particular funds in large part because in fixed income though the principles are the same, it's a smaller sample set, there's a much, much fewer data points. But across equities, they simply did a regression analysis and found that most of these strategies fell, not most, all of these strategies really fell into six pretty distinct buckets.
I'm going to quickly define them because it's important as we think about how different ways to use ESG factors into investing actually matter and how they differ. You have the active ESG engagements, these are the activists we just talked about, right? They're actively seeking to impact companies and only really focusing on good guys and really pushing people. This is the classic impact sort of approach. But you also have the ESG integrators and full disclosure, that's us. That's the kind of thing we do. And what that is you take these ESG risks and you integrate them into fundamental analysis, not an overlay, not a screen, not something that happens after the fact. It isn't one of those, I have my happy portfolio and I'm going to make it a little worse for you because you care about ESG factors, right?
That's not how the integrators think. The integrators actually integrate the analysis of ESG risks into their analysis of other risks. You have the budget-focused folks, so I'll define that. Budget means lower fee, focus means focused in on a single issue. So for example, animal rights or particular, well, climate change or something of the sort. Why there's not a non-budget focus group I think is in large part because these types of funds are run by very, very large investment company, investment managers. And because you kind of need to be really large in order to be able to subsidize a fund that is such a specialty fund because there's just not enough demand for it to have it be a standalone business. So those firms tend to also have the economies of scale to market lower fee strategies. Then on the negative screening side, you have the passive screens, which are the most obvious kind of piece of the screening world, which is literally just, let's just take the index and throw out some bad guys based on some third party rating system.
You have the outsource, but the passive screeners, just to be clear, they are trying to be indexed. So they don't use necessarily like the Sustainalytics MSCI, they don't use the outsourced research folks, that's the outsourced screeners in the next category. They actually just find other ways to somehow have essentially an indexed, passive indexed, ESG-oriented strategy that they tend to have lower turnover as a result. The outsource screeners are the folks that you can imagine start with an index and they say, "Okay, I am committing myself to whatever Sustainalytics has to say, some third party research firm or what MSCI has to say, and I am going to therefore exclude those people that are not good." Now, this is important to distinguish because it's not that firms that do ESG integration, it's not that firms like Osterweis don't consider the research of these firms in our identification of where risks are and how we evaluate them.
It's just that we don't outsource the decision with respect to the sustainability side of our portfolio to those firms. So in the same way that as a credit manager, I'm not going to buy a bond because JPMorgan said it was a buy, or sell a bond because Goldman Sachs said it was a sell. I'm going to do my own work. Similarly, we might reference these third party services such as TruValue Labs or Sustainalytics in informing our own research, but we're ultimately doing the work of actually evaluating a company and where they are with respect to their ESG factors, the outsource screeners don't. They adhere very strictly to this third party screening framework. And then there's the budget screeners, which I'll be truthful and honest with you, I don't exactly know who these people are. I think again, it's very large investment management firms that sit somewhere between this passive approach to screening and this actual outsourced research. The main characteristic there is that they're lower fee.
So the folks at Wharton took these six categories of funds that fell out of their statistical analysis and they segmented them by fee level, by average ESG score relative to the benchmark. So they used third party scoring systems in order to just say, hey, which of these approaches tended to score better with respect to ESG characteristics? And then which ones actually had a positive correlation between performance and progress - between their investment performance and their ESG performance, which is the holy grail?
This whole conflict of performance versus progress is one of the biggest criticisms you hear about ESG. And so I'm going to say, I'm going to tell you one of these six categories only both had high ESG scores and had a positive correlation between performance and progress. So we're going to ask you all in the next poll to guess which one you think it is. This is where we need the music. So waiting, I would say, I guess I can say Jeopardy music. We don't have to pay Jeopardy for that to say their name. So try to get what we're asking for is which of these do you think is actually the one that had a positive correlation between performance and progress, and in that nature also had a high progress score, ESG score. How are we doing Paige? They coming in?
Paige Uher: They are coming in. I'll give you five more seconds.
Venk Reddy: Let's see the results.
Paige Uher: I actually like being the first one to see the results.
Venk Reddy: No. So 60% of you picked the right answer, which is the ESG integrators. Let me get back to my screen here. Every time you pop those up, it takes the focus from the screen. So I'll quickly, and so this ESG integrator group is the one that had both a top-tier ESG score performance and positive correlation between performance and progress. Four of these categories had negative correlations between performance and progress, and one had none. It is not lost on the folks at Wharton that these top two categories are the high fee categories. And the reason for that is risk analysis takes work. I mean that's really what it comes down to, right? Risk analysis takes work. Doing the analysis on risk, especially over long time frames just takes work, so that you're going to end up in more actively managed portfolios as a result.
Now the question I have for the 60% of you that agree or that identified, even for everybody really that identified this, as the area where we see the least conflict or not really a conflict between performance and progress is why all the money is going to these two categories. So what they also found was the overwhelming majority of fund flows were going to these two categories of screeners. Notably, they're not the low fee categories. So it's not that people are just going to the lowest fee. They're actually going, and I believe the reason for this, and the folks at Wharton seem to agree, one of the reasons for this is simply speaking this concept of good and bad. This good versus evil kind of framework that we have in the world of investing with the ESG factors makes it very easy, right? It's easier to market all these firms, every firm that runs money, as you all know, the people on this call are good at marketing.
That's the one thing we're good at. Not everybody's great at investing, they're all great at marketing. So it's much easier to market and sell good versus evil than it is to market the nuance of, well, hey, we're really looking for companies that consider these factors as risks. Risk management is just harder to market than something that's so stark and as a good-versus-evil debate, which is fine. The problem is our friends at Wharton also notice that because the fund flows are going and benchmarking, the bias is toward these firms that are one point in time ESG scores. They're actually not going to what they deemed ESG improvers.
So companies and portfolios where the underlying investments are actually making progress and improving. And for those ESG-focused investors who are looking to have impact with their capital, the idea that you're going to invest only in the good guys and not in companies that are making progress and improving actually runs counter to the objective. It's like being in a classroom, right? And if I'm a teacher and I have a classroom, it's like me only paying attention to and patting on the head and giving hugs to the kids that are already getting As. When really if I want to improve the whole classroom, what I should be doing is identifying those students that are C students and want to become B students.
And I want to encourage them to make that progress. And it's not that I'm not going to also congratulate the A students and I'm not going to focus on other students, but I want to encourage the entire class to improve. It does require the class. It does require the companies to want to improve. It requires intentionality on the company's part. But this notion of being an improver is a material alignment with a lot of ESG investors that they're just not getting with the predominance of strategies in the marketplace with a lot of new entries coming into these categories, because that's where the assets are going. So this is a really important point. We want to move ourselves away from this notion of ratings of good versus bad and move to word a notion of progress. So what you see here, it's actually specific to our firm. We call it our Sustainability Spectrum®.
This is how we think about the ESG risks in our companies. It's not that you're looking to have somebody who's always good, it's that we want to know for any given risk, is the company aware of that risk? Do they have a strategy to manage that risk? Are they executing on that strategy and are they measuring, reporting and holding themselves accountable? Now, the reality of it is this spectrum, this concept is something that we use for all risks associated with our credits. If you think about leverage, I do the same thing. Are we aware? Is a company aware of its leverage and appropriate level of leverage? Does that have a strategy to manage its leverage? Are they executing on that strategy? Are they measuring reporting and holding themselves accountable? The SEC requires companies to report in 10-Ks and Qs, the information that we need to hold them accountable for that measurement end.
On the sustainability side, on ESG factors, that's not as clear. So it takes more work, but at the end of the day, what we're looking for, we're not looking for all companies at the bottom end of this spectrum. You're looking for companies that are looking to make progress, that are intentionally aiming to make progress along this spectrum. And for those investors, by the way, that are not mission-driven, that just maybe they don't care about making progress along here. What's really important to note is making this progress and looking to make this progress is the equivalent of being aware of risk. And while you may or may not believe a specific ESG risk is or isn't material to a company, there's one thing that is clear, a management team that's focused on its risks that can identify its material risks, and there will always be an environmental and/or social and/or governance risk that is material to a business.
A management team that's aware of their risks and managing their risks is more likely to end up in the future in a place that investors expect them to and want them to than a management team that's not. So it actually does align that performance versus progress, which otherwise would've been in conflict. And so with that, I'm going to actually hand this over to Marcus and he's going to talk us through a little bit more specifics around credit analysis in particular, but you can think of it as fundamental analysis for the purpose of mitigating risk in portfolios.
Marcus Moore: And so thank you for joining us today. Just to get a highlight and apologies to Montell Jordan, but "this is how we do it." From a credit analysis standpoint, we kind of look at these three factors, financial, business, sustainability, sorry. Financials - pretty easy to get your arms around, right? There's a number for leverage. There's a number for free cash flow. There's a number for liquidity. Business factors are a bit more qualitative in a sense. You can talk to a management team, get a sense for them, you can kind of talk to people within the industry or other companies to get a feel for where a company sits competitively. You can go through the documentation to get a sense of what your covenants are, your lender protections, et cetera. And then you have these sustainability factors, environmental liability, stakeholder treatment, et cetera. Historically, the first two have been very easy to think about, even though one is very quantitative, the other is qualitative.
But one of the things that is out there that you can use and that we use is SASB has basically created 26 ESG categories that could potentially pose material risk to companies. Each company is subject to not all 26. It's basically tied to which industries you're in to identify which specifically within those 26 risk factors a company is actually most materially exposed to. So with that framework, you can begin to have a dialogue with companies. And that's one of the things we try to do is really as we're going through our credit analysis, obviously, we care about the leverage, we care about your free cash flow generation, we care about the quality of your management team. We want to understand if you're a cyclical business, you're a defensive business, pretty steady Eddie. But also, we want to get a better way to get our arms around sustainability factors and for companies that we invest in given the various sizes.
Yes, there's some companies out there that are publicly traded that produce the large corporate social responsibility reports every year. And you can go through those 35, 40-page documents to get the things that they want to talk about as it relates to ESG. But more often than not, the things that are hidden underneath the surface are not going to be in that CSR report. So the SASB foundation is really good in the sense because it gives you a starting point to kind of address specific issues with companies that they may not necessarily want to talk to you about, but are very important in terms of understanding the long term risk that this business could potentially be exposed to. So in the next slide, we have a few examples that we like to talk through. The first one is PetSmart. We use red because this is definitely a dangerous situation for people who care about sustainability. In 2017, PetSmart was performing reasonably well, but the market at that time was very concerned because they didn't have an internet presence. So they had a large competitor out there, Chewy, that did everything online. So PetSmart decided to raise $3 billion of debt and buy Chewy. That started off, market was very excited. It was like a blowout new issuance. Everyone wanted a part of that deal. Everyone was excited. A year later, the fortunes had turned because at that time, Chewy was still negative EBITDA. And so now you bring Chewy's negative EBITDA business onto the PetSmart books. Now your leverage metrics look worse, your free cash flow metrics look worse. Investors get concerned. So PetSmart said, "How can we alleviate our investor concerns?" Well, they decided that the best way to do that was through a series of transactions to strip away the guarantees that the Chewy assets provided to the debt holders who gave them the money to buy Chewy in the first place, strip away those, strip away that guarantee to make it that Chewy was no longer a guaranteed sub.
So Chewy's negative EBITDA is no longer on PetSmart's balance sheet. So the balance sheet looks better, cashflow's better, but as an investor, you now have less protection because while yes, Chewy was a negative EBITDA company, PetSmart had just bought it for $3 billion, that's a significant amount of enterprise value that had just been stripped away from you just because the company wanted their balance sheet to look better. So fast forward, that was 2018, fast forward now to 2020, PetSmart is now deciding that they want to spin off the Chewy asset and refinance their entire capital structure. They come to market with a deal at a time that was relatively favorable within the capital markets, and debt investors were like, "Hold up. We just literally watched you strip $3 billion of assets away from us using a covenant loophole. How do we know you might not want to do something like that again?"
And so they required a much higher interest rate and also in incremental covenant protections that were a bit more onerous than what was being offered for most standard deals on the market at that time. So at the time, PetSmart's management team decided they'd back off, waited, didn't get a deal done then, but then came to market in 2021, but did have to acquiesce to a higher cost of capital and incremental debt covenants because again, investors remember that activity. So as we think about our credits and creditworthiness, access to capital markets is a huge part of that, especially given a short duration of portfolio. Within the next year, two, three years, our companies are going to need to refinance the debt that we hold for us to get our return on our investment. So when you have management teams that are doing or taking on those type of very just out and out wrong, evil, whatever adjectives you'd like to put in front of it, actions against its debt holders who gave them the money to buy this asset in the first place, that's a challenge.
And so when that takes place, that puts your access to capital at risk. And so those are the type of governance scenarios that we really try to avoid, so that's why that gets obviously the red light. A yellow light is more of something a caution and kind of look into with more depth is the Lionsgate situation. So Lionsgate is basically three different businesses under the Lionsgate umbrella. You have the television and film production element of it. You have the Starz television network, and then you have the library of content from movies that Lionsgate has acquired under its umbrella over the years. So it was late 2021, the company had decided that they were looking into spinning out the Starz network. For us, we kind of viewed the Starz network as an attractive asset within the Lionsgate family because you have a very highly cyclical television movie production business buffered to an extent by a very steady Eddie, strong free cash flow generator, but not really.
There's not a lot of revenue growth for the most part, but steady free cash flow in the library. And Starz provided a really nice mix of kind of potential for growth, but also strong leverage metrics, strong free cash flow generation. And then it also really was in our opinion, one of the crown jewels of ESG story there, because the Starz network really is focused on diversity. It primary programming audience is minorities and women. They actually take great pride in having minority women leads. They actually, almost every show that is a Lionsgate, sorry, is a Starz Network programming has either a minority or a film runner, and that's a very rare thing in Hollywood. And that's one of the things that network was championing through their efforts. So as we heard about that decision, we kind of asked questions to management. And at the time, given it's still a pending transaction, and actually most recently the company now has just stated they may spin the television and movie division off.
But that said, for us, that uncertainty around what the Starz or what the Lionsgate asset would look like long term, what would the remedies be if they were to spin Starz out from us as debt holders? That uncertainty forced us to be much more cautious around that investment and kind of look for better opportunities that had kind of a much cleaner story. And then finally, the green scenario, or the green example would be American Greetings. I think most of you know that the brand known for greeting cards. The industry is kind of maligned for the fact that most people think that no one gives out greeting cards anymore, that it's going to go the way of the dinosaur. But that's not totally true. You have seen decline in kind of the physical greeting cards, but you've also seen an uptick, a meaningful uptick in the sending of digital cards in the store like that.
And that's actually a higher margin business for American Greetings. So that shift on a dollar per dollar basis is actually beneficial to the company. But that said, during our due diligence, we sat down with the company and had a conversation and kind of really wanted to get an insight on, okay, you're in a business that everyone assumes is going to be declining, so that puts pressure on EBITDA margin, that puts on pressure on cash flow. What are you doing to offset that? So the thing the company really talked about, and again, this is a very small company. They're not large enough to put out the 40 page CSNR report, but for their own preservation in terms of managing leverage, cash flow, et cetera, they realize that one, investing in their employees was a very important thing to do. And so while again, when you see companies that are facing top line pressure, one of the first things a lot of companies will do is they'll just lay people off.
But what American Greetings said was for them, having employees who are experienced, happy, and engaged actually helps their bottom line, because more often than not, it's going to be those employees that make the suggestions to drive greater efficiencies to help generate cost savings projects and are the ones who are going to execute against those cost savings projects. And then the second part that they kind of mentioned was as they work with customers, their customers were also looking for recyclable or more sustainable solutions. So one of the things that they came up with was a significant, their packaging materials and their marketing materials, the end caps you'll see for Halloween, that's coming up recently or in a couple days, Christmas, Valentine's Day, graduation, et cetera, historically, those, the displays were basically printed one time, put in the store, and then thrown away. What they realized is that they could be much more strategic about how they make these products making them much more sustainable.
So there's an element of the packaging that's reusable. So there's like a frame associated with it. So that frame, you can use it for Halloween, you can use it for Valentine's Day, et cetera. And then making the product of a certain quality so that it could actually stay for one or two seasons. So that cuts down on the use of paper, the cost of shipping, that cuts down on the storage process and what the companies that their customers had to do to kind of maintain those displays. So what you've seen from American Greetings as a result of that is despite top line growth that's kind of in the low single digits, you're seeing margin expansion and EBITDA growth and very strong free cash flow generation. And a lot of that has been driven by their focus on sustainability around employees and recyclability and overall business sustainability. So with that, we'll actually pass it back to Venk so we can talk more about where does this fit.
Venk Reddy: Thank you, Marcus. And look, I think this is a really important - the big takeaway there is: ESG risks, material ESG risks are, impact underlying fundamentals, right? It's not some extra thing. It actually does drive whether a company can perform. And I think that's something that I think folks kind of forget that these risks existed before the term ESG was something that woke people up and will exist long after a new term has come along. And that's particularly important, but it's not always a fit for everybody, right? And we are not here to say everybody in the world should have a hundred percent portfolio with an ESG-aware strategy, because it may very well not be a fit for everybody. So where does it fit? I'm going to start with a framework that we've used for a long time in thinking about how investment products and investment management breakdown. We start with this top level breakdown of passive versus active.
I mean, gosh, I think some of the folks on this call might have been in diapers when this debate was raging at its loudest. I sadly was not. But if you really dive a little bit deeper, you have these various sort of subsets in these areas. Now, passive is passive. It's a beta-oriented approach that it's essentially trying to have low deviation or no deviation, little to no deviation from benchmark. It's basically index investing. Active breaks down into a couple of different categories. And it's important to understand these different categories. Number one, there is the active beta. This is the primary focus is relative returns. You may have heard the term tracking error. This notion of not wanting to deviate substantially from the benchmark, but still wanting to use some incremental and incremental is key there, security selection to outperform the benchmark while not deviating substantially from it.
Think of it, if the index does this, then they want to do actually right now, maybe the indexes does this and they kind of want to do this. And then there's the risk managed group, and this is where we fit. This is where Osterweis as a firm tends to fit. Whether you think of it as risk adjusted returns, maybe some folks in this category are targeting absolute returns. The goal is security selection and risk mitigation. There's a little bit more of a tolerance for deviating from the indices, potentially underperforming to the upside and outperforming to the downside is something that you hear. Investing for the long term, it's another way of thinking about it. It's really a risk focused, risk aware subset of a portfolio that results in a deviation at times from the index benchmarks and results in it for a very explicit reason.
At the end of the day, there's a lot of irresponsible ways to make money. I talked about that before. So there's certain markets where outperforming to the upside means that you've taken excess risk, even in excess of what is probably responsible for a particular place in an allocation. Maybe not in certain parts of the allocation, but in other parts of the allocation. So risk managed strategies tend to fit in that little bucket. And then there's a non-economic, this is kind of where a lot of activists in the case of ESG, it's where a lot of impact investors and activist's type of portfolios will fit because economic performance is not the only objective of that particular portfolio. There might be a double bottom line or intangible objective. So what I've done here is I've actually taken our categories from before, our investment styles from before, different investment styles that use ESG factors.
And I've kind of mapped them to what, so where they fit. And the color is, I'm going to take off my ESG evangelist hat or my ESG kind of mission-driven investor hat, and I'm going to put on my traditional investor hat for a second. Because I think it's really important to know that what we're looking for here, the fit with ESG-oriented strategies is not just a function of which style of ESG investing you believe in or don't believe in. It's also which style of manager you're looking for or that you gravitate toward, and where that overlap is. And then does the resulting portfolio that you choose meet your goal. So for example, if you're a passive beta investor, for anybody on, I'd be surprised, but if we have people on this call who do nothing but index investing, the most passive screening approach to ESG may or may not be a fit for you.
It's marked as red, because really, if ESG risks are long term risks and the portfolio's job is to meet a benchmark in short term timeframes, you're going to have deviations you don't want. So it's highly unlikely that an ESG-oriented portfolio, certainly a passive portfolio, is going to meet the needs of the investors that might want it. Ironically, it's getting off roles, but it's really not. It's across purposes to the folks that actually it would be a fit for. Similarly, if you're more of an active beta oriented all allocator, and you're looking for folks that have low tracking error, but are deviating from benchmarks, that are not deviating materially from benchmarks, the other screening approaches, possibly the integrators could work for you. But at the end of the day, the place where there is the most alignment between the investment style using ESG factors and the risk focus or goals of the allocator fall in this risk managed area with the integrators.
Because at the end of the day, that is the risk management approach to investing. It is considering risks, evaluating their impact on a company's fundamentals, both in the short, medium, and long term. And then putting together a portfolio that aims to be a collection of well-researched and well-selected issuers and risks. And that very much dovetails with what ESG risk analysis and this notion of ESG integration really is. Now, once you get to the non-economic side, all bets are off. For the ESG evangelists, for the mission-driven investor, all of these styles are fine because you don't care necessarily. I don't want to say you don't care, but you're less concerned about deviations from what your expected risk and expected return targets are as you are with where a portfolio is in its evaluation of ESG factors. But for the traditional investor, there's only a subset of these that really could work in a way that fits a traditional portfolio.
At some point, we're happy to tell you a little bit about the use of the portfolios that we have. But just in general, it becomes a difficult thing for traditional investors to choose portfolios that are ESG for ESG's sake. I think that's kind of the way to put it when you think about this notion of negative screening. So one of the biggest problems. Okay, let me take a step back here. For all you allocators on this call, I don't envy you. And I don't envy you because the biggest problem in the ESG marketplace right now is not whether ESG works or doesn't work. This debate, and it's a common argument, but it's not really whether using ESG factors works or doesn't work. It's that so many people have entered this marketplace.
And now your job as an allocator is to differentiate those managers, those strategies that are performative, that are ESG for ESG's sake, for the purpose of marketing, for the purpose of trying to land grab some market share of this growing subset of the investing world versus those that are sincere, that actually are integrating or considering ESG factors in a way that actually delivers a portfolio that their clients are looking to have.
Whether those are, going back one slide, whether those are the non-economic folks or other folks that maybe aren't as concerned about the performance versus progress trade off, or whether it is investors that really don't want to have to make that choice. So that's one of the biggest challenges we have in investing. I'm going to dive into fixed income here for a second. I'm going to try to do this quickly because we're running low on time and I want to make sure we have time for questions. But one of the most common areas of discussion within fixed income that brings this question to my mind, I don't know that everybody's asking the question, is green and sustainability-linked bonds. Hopefully, most people have heard about them. For those who haven't, the way these bonds typically work, they're typically issued by investment grade companies. They tend to have this notion of in the bond itself, in the issue, it's an issue specific kind of thing.
In the bond indenture, you'll have some language around, if a company meets some ESG target, their interest rate, the coupon they pay goes down by typically it's 25 basis points, give or take. Sometimes it's an eighth, sometimes it happens. Most of the time, it's like a quarter of a percent, or if they miss a target, then their coupon goes up by 25 basis points. So on the surface, if you just think about what I just said, it kind of makes sense, right? Like we're aligning, the company has to pay more if they don't do well, and therefore they're incentivized to not do well. But I'm less concerned about the incentives of the company, and I'm more concerned about the incentives of the investors. So let's start real quick with the companies. Most of these companies, an extra 25 basis points on one bond issue issued out of some special purpose vehicle is not going to make or break their company.
So it's cheap for them to fail. They don't want the reputational hit of failing, but it's cheap for them to fail. But what's worse is that for the managers, for the investors that are buying these bonds, think about this, right? If the company doesn't have some existential risk, if they don't have a risk of default because their interest went up, the investor buying the bond gets a higher total return if the company misses its target. So the manager of the fund that's investing in green sustainable bonds, whether they know it or not, all of them are this evil, but whether they know it or not, the incentive to get the highest possible total return is an incentive to choose companies that are going to miss their targets, but not by so much, but not have such a big impact on their business that they actually aren't going to eventually pay off the debt.
And that's a problem. It's an example of where this ESG approaches can be very performative, right? It looks good, it sounds good on paper, but the reality of it is it's not actually a sincere effort to deliver a portfolio that meets a mandate that most investors in ESG are traditional investors who believe in ESG risks actually care about. We are years away from the necessary structural changes to write this misaligned incentive. And I'm happy to talk more about that later in Q & A or in a subsequent conversation if folks choose to dive into that more. But it's really important to recognize that when you compare that to what we've been referring to, right? Sustainable value, sustainable credit, it's ESG integration approach. When you're factoring ESG risk factors into the credit analysis where you are, it's an issuer focus and a risk-focused approach, not an individual issue focus.
And you're rewarding companies for making progress. You're using the capital to reward companies to make progress in the cases where you're dealing with material risks, ESG risks are not, but we're talking about ESG risks today. When you're dealing with material risks, a company's creditworthiness is very much correlated with a management team's focus on the risks that impact their business, both in the short and in the long term. And so now, and if a company is not creditworthy, investors, bond holders, lose money. And so you've aligned the incentives of the investors, you've aligned the goals of progress with the financial performance of the company if you take this more integrated approach. There's a reason that the statistical analysis from the folks at Wharton came out with this type of an approach actually being the one that has a positive correlation performance in progress. Because the nature of what you're looking at is not just an ESG risk, it's actually a fundamental risk.
Those two are not different things. If you're looking at materiality and the reason that you would prefer, I think one would prefer a manager that focuses in on that actually has an explicit effort on ESG risks is I can, off the top of my head, name two, three risks in any given company that fall under this ESG categories. But if I start with 26 and I whittle it down to the ones that are material, I can assure you that list is bigger than the two or three I would've come up with if I was trying to start from nothing. So again, it allows us to focus on evaluating more risks and having as much confidence as possible that we have companies that are considering the risks that underlie their business. The problem obviously is if you're putting credit portfolios into an asset allocation, you have to be careful that you're not doubling down on risk.
So you're probably not doing this with in your core fixed where they broad market high beta of high yield approach. You're going to want to do it with something that actually is risk managed. Let's remember what we talked about, risk managed, right? We talked about the fact that you're looking for managers that look to manage risks so they can deliver a profile that fits one of those pies in your asset allocation pie chart. And then really correlates to this notion of mitigating as many risks as we can mitigate in the analysis that we do or that fundamental analyst does.
And the way we do that is not just by evaluating risks, but also evaluating management teams for their effort to mitigate the risks in their underlying business. This is credit analysis, this is fundamental analysis. This is not something different or other. So managing risk, basically what I'm saying, managing risk is key, but isn't it always, right? So speaking of risk, we have one more poll for you before we move on to the last point. And then I guess we're running too low on time here, but we'll see what we can do at if we get questions coming into the box.
Paige Uher: So here's our last poll question, if/when I select a manager for an ESG aware strategy, I and my clients are most worried about: greenwashing, performance versus the benchmark over a one-to two-year, or performance versus benchmark over time.
Venk Reddy: I think I probably led this question with my whole presentation, at least in some capacity.
Paige Uher: Well we'll see if they were listening...
Venk Reddy: But while we're getting the answers to this question, I think it's really important to really think about the risks. So when the regulators walk into an investment advisor's office or investment manager's office or whatever, and we are fundamental credit managers, I think most people know that. Interesting, so we'll talk about this in a second, but most people know that we're fundamental credit managers. So when the regulators do an exam, they don't ask a fundamental manager to pull out their credit models and prove that they were building credit models, right? But for some reason with ESG, because there's so much focus, because there's so much risk of defrauding investors, quite frankly, the regulators are extremely focused on making sure people are doing what they say they're doing. And so the question really that comes up here is, so the answers were greenwashing performance over time, which are both risk areas.
The second one is what we've been talking about all along the risk in the underlying issuer. The first one, however, is exactly what we're talking about now, is who you can trust. Because now regulatory risk is investor risk, right? For anybody who has clients who are mission-driven, in particular, if you are picking managers that are focused on ESG risks, it's actually materially impactful to you and your clients. If a manager that you've selected then has the SEC walk into their office and write them up for not doing what they said they were doing, that's actually a real risk now. It's a real risk to advisors, it's a real risk to managers, it's a real risk to investors. And so, like I said, all of these firms are really good at marketing, but at the end of the day, what you want to make sure is this is where identifying those folks that are sincere, running them through the due diligence, proving that they're doing what they say they're doing.
And knowing that that's less of a risk or they've mitigated that risk in some way is really, really important in a way that it was not even as important for traditional strategies who would make claims that they would then never have to prove to anybody, and they were just being judged by performance. So look, just selfishly what you see up here is among other things. One of the ways we do this at Osterweis is we actually have built software that basically aligns with our research process and that actually fits with what we've represented in our prospectuses and to the SEC that we do in the work that we do. And every firm is going to have their own version of something. Well, I don't know about actual in-house piece of software, but every firm should have some version of how they demonstrate they're doing what they say they're doing. And that's something that's really important because regulatory risk is real. It is very real. And anybody who got their funds launched years ago and can run around calling themselves responsible or sustainable or whatever are not immune because the focus on this area was not there than the way it is now. So language that might have been acceptable, loosey-goosey, wishy-washy language, it might have been acceptable years ago to give managers maximal optionality to do something different than what they say they're doing.
It would not pass muster today and it certainly won't pass muster in a regulatory exam today. So I hate to end on that note, but the good news is that might be a little bit of a downer note, but I'm going to uplift you because now that I'm done speaking, the lawyers have something to say. So here are the relevant disclosures for this particular presentation. And I know we're a little over 2:00 so I apologize. But if we do have any questions we have, we have a few extra minutes to go into some Q & A and we can all obviously follow up with folks afterwards as well.
Paige Uher: So thank you all for attending. We are at time, so anybody who has submitted questions, we will reach out to you and address those. So thanks again and this will be available on replay for colleagues and anyone else that you think might be interested as well as the slides and some of the data. So thank you, Venk. Thank you, Marcus, and thank you all for being here.
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Opinions expressed are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
Nothing contained on this communication constitutes tax, legal, or investment advice. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation.
ESG refers to Environmental, Social, and Governance.
A covenant is a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. Covenants are put in place by lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g., depreciation) and interest expense to pretax income.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization.
Alpha is a measure of the difference between the portfolio’s actual return versus its expected performance, given its level of risk as measured by Beta. It is a measure of the historical movement of a portfolio’s performance not explained by movements of the market. It is also referred to as a portfolio’s non-systematic return.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
Tracking error is the standard deviation of the difference between the returns of a portfolio and its benchmark.
Investment grade bonds are those with high and medium credit quality as determined by ratings agencies.
Coupon is the interest rate paid by a bond. The coupon is typically paid semiannually.
Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.
A basis point is a unit that is equal to 1/100th of 1%.
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The Osterweis Sustainable Credit Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility, or illiquidity compared to higher-rated securities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The Fund is non-diversified, meaning it concentrates its assets in fewer individual holdings than a diversified fund. The Fund may invest more than 5% of its total assets in the securities of one or more issuers. Fundamental investing that integrates sustainability factors will entail deviations from the benchmark, potentially without resulting in favorable Environmental, Social, or Governance (ESG) outcomes.
The Osterweis Short Duration Credit Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility, or illiquidity compared to higher-rated securities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The Fund may invest more than 5% of its total assets in the securities of one or more issuers. Fundamental investing that integrates sustainability factors will entail deviations from the benchmark, potentially without resulting in favorable Environmental, Social, or Governance (ESG) outcomes.
Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20221028-0662]