Why sustainability pays dividends

Many factors drive the long-term resilience of a business and therefore the resilience of its earnings and dividends. Industry structure, disruptive threats and pricing power are just a few of the factors our team analyse to build a forward-looking view of the prospects of a company. Another key aspect is to analyse a company’s stewardship of their business. Are strategic, operational and capital allocation decisions aligned with long-term value creation? Crucially, to answer this question we must consider the company’s management of its environmental and societal impact and whether company management are truly considering the long-term horizon.

Focusing on material risks

When carrying out this analysis, we must acknowledge that different businesses face different environmental and social challenges. For example, for our holdings in the water intensive semiconductor industry such as TSMC, water reduction policies should be in the spotlight. For our consumer staples holdings such as Unilever, the impact of their plastics and recycling policies are of greater importance. For the few relatively more energy intensive holdings in the portfolio such as industrial gases business Air Liquide, the company’s carbon reduction goals are one of our key areas of focus.

Fidelity’s sustainability ratings provide the framework for focusing on the issues that matter and weighting them accordingly. Key indicators are identified and weighted according to their individual subsectors. These are supported by 130 underlying data points, alongside analysts’ qualitative assessment for each indicator.

Integrating sustainability into risk analysis

Poor management of environmental and societal risks can have a meaningful impact on future cash flows, whether through higher regulatory costs, litigation, brand erosion or stranded assets. We’ve seen examples of this with product miss-selling in the financial services industry or environmental liabilities leading to substantial fines for industrial companies. Sustainability analysis is a key part of a dividend investor’s toolkit to ensure companies are appropriately managing these risks and protecting the cash flows that support dividends.

This focus is also complementary to our emphasis on risk that is embedded throughout the strategy in order to deliver lower drawdowns than the market during stressed conditions. This begins at the stock specific level when sustainability risk is assessed alongside business model risk (will the company’s operating model prove resilient, are management demonstrating good governance in terms of capital allocation), financial risk (does the company have an appropriate level of debt on its balance sheet, are there poor environmental or societal practices that are likely to create significant off balance sheet liabilities) and valuation risk (are we overpaying for the business).

At the portfolio construction stage, we allocate the highest weighting to those stocks with lower estimated downside and lower weightings to those stocks where the range of outcomes is wider. Sustainability, therefore, forms a key building block of this multi-faceted approach to risk management.

A growing source of resilient dividend growth

However, sustainability does not just mean managing the long-term risks. It also presents potential opportunities. The large-scale shift towards a sustainable economy globally can offer sources of future dividend growth across a range of different sectors.

Portfolio holding Schneider Electric in the industrials sector is one such example. It is the market leader in automation and energy management systems which are seeing growing demand from companies increasingly looking to reduce their carbon footprint to meet net zero targets and reduce energy costs. Similarly, European utilities Endesa and Iberdrola offer attractive yields and reliable, regulated returns, while their significant investment in renewables also has the potential to drive future growth.

Dividends and strong governance

Dividend sustainability is strongly linked to effective governance and sensible capital allocation. Well governed businesses with appropriate levels of debt and low off-balance sheet liabilities are better able to withstand different economic environments, while still maintaining profitability and therefore their dividends.

The impact of Covid in 2020 shone a spotlight on the difference between companies with strong balance sheets and good historical capital allocation versus those with stretched debt levels and poorer capital allocation track records. Companies in the former category were able to maintain their dividends over that difficult period and those in the latter category were typically forced to cut their dividends.

Dividend policies may also in turn be supportive of good governance. Management’s commitment to an appropriate dividend can lead to a strong alignment of the interests of management and shareholders and can also help prevent managers from mis-allocating capital to potentially value destructive initiatives.

Fidelity’s sustainability ratings and dividend growth

Notably, initial historic data appears to show a positive relationship between higher standards of sustainability and better dividend outcomes. The chart below looks at Fidelity’s sustainability ratings (which grade c. 3,700 companies from A to E) and their historic dividend growth. The analysis illustrates that companies with better sustainability ratings have delivered higher historic dividend growth. In fact, on average, companies rated A for sustainability have the highest levels of historical dividend growth, with D- and E-rated stocks delivering the lowest average levels of growth.

Highly-rated ESG companies have delivered superior dividend growth

^{Source: Fidelity International, July 2022}

We therefore strongly believe that a focus on sustainability is highly complementary with a dividend-based approach to equity investing. The attributes of resilience and reliability that we seek in a company go hand-in-hand with a strong corporate culture of risk management. Ultimately, if we want to access sustainable and growing dividend streams then we need to invest in sustainable companies.

Aditya Shivram, portfolio manager, Fidelity Sustainable Global Equity Income Fund

Learn more about the Fidelity Sustainable Global Equity Income Fund

Important information

This information is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up and you may not get back the amount invested. Past performance is not a reliable indicator of future returns. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in emerging markets can be more volatile than in other more developed markets. The Fidelity Sustainable Global Equity Income Fund can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The fund takes its annual management charge and expenses from capital and not from the income generated by the fund. This means that any capital growth in the fund will be reduced by the charge. Capital may reduce over time if the fund’s growth does not compensate for it. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. A focus on securities of companies which maintain strong environmental, social and governance (“ESG”) credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security's ESG credentials can change over time. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0922/370898/SSO/NA