Sustainable, Responsible &/or ESG Policy:

The Fund has a dual objective: an investment objective and a non-financial environmental objective. The Fund’s non-financial objective is to seek a significantly lower Greenhouse Gas (GHG) emissions intensity than the reference benchmark, the MSCI AC World Index. The portfolio has a significantly lower carbon footprint than the broader market – 87% lower than MSCI World on a Scope 1 and 2 basis per $m sales, and 95% lower on a Scope 1 and 2 basis per $1m invested (data as of 31 December 2022. Source: S&P Trucost.)

Global Sustain offers investors the following features:

ESG integrated research: our team assesses the material ESG risks and opportunities for every stock as part of our fundamental, bottom-up research. We use our proprietary ESG scoring framework, the MRI, to flag any material ESG-rated risks or opportunities and identify areas for engagement. We have also conducted comprehensive, stock-by-stock analysis across the portfolio to assess the carbon transition strategies of our holdings, including any reduction targets they have set.

• Active ownership: As active managers running concentrated portfolios and with a long-term investment horizon, we believe we are well positioned to engage with management on financial and material ESG topics and encourage companies towards better practices. As detailed in our 2022 January Global Equity Observer, “Climate Change: Everyone’s Business”, we have been conducting an ongoing carbon transition engagement programme, aiming to understand the climate profiles of the companies we own, and encourage progress. This could involve seeking better transparency and accountability, challenging well-meant targets that lack credible pathways or, for those already on the right track in terms of disclosure, targets and actions, engagements are used to monitor performance and encourage continued leadership.

During the first phase of the carbon transition programme we focused on encouraging companies to adopt or strengthen carbon reduction target and assessing the feasibility of targets. We engaged with 95% of our holdings in this Phase. During Phase 2 of our carbon transition engagement programme , we continued to advocate for better outcomes in four focus areas:

(i) improved transparency and disclosure;

(ii) the strengthening of targets to net zero and the adoption of science-based targets and Scope 3, where missing;

(iii) better alignment of management incentives, pressing for environmental and social targets to be tied to executive compensation in order to drive their fulfilment; and

(iv) moving the conversation onto nature-based solutions and physical asset risk.

We also used voting to reinforce our support of the companies in our portfolios taking positive actions in relation to climate change. Over the course of this phase, the team engaged with 55% of the Global Sustain portfolio on decarbonisation.

• Exclusions: the Fund has a robust set of carbon-related exclusions in addition to restrictions on some of the more contentious industries and sectors, as set out below:

The investment team applies a number of exclusionary screens including a Greenhouse Gas emission intensity filter and sector/industry exclusions to the initial universe.

• Greenhouse Gas (GHG)[1]Emissions Intensity Criteria Exclusions:

The following are excluded:

• Any company with any tie to fossil fuels, as classified by the MSCI ESG Business Involvement Screening Research (BISR) database[2]
• Any company assigned to the following MSCI Global Industry Classification Standards (GICS) sectors or industries:
  • Construction Materials
  • Energy
  • Metals and Mining
  • Utilities (excluding Renewable Electricity and Water Utilities)[3]

The remaining issuers are then ranked according to their GHG emissions intensity estimates and those with the highest intensity are excluded. These exclusionary screens aim to reduce the universe by at least 20%.

• Sector/Industry Exclusions

We further screen out the following sectors or industries that fall under the MSCI GICS classification of:

• Brewers
• Casinos & Gaming
• Distillers & Vintners
• Tobacco

In addition, we screen out any company whose core business activity involve the following:

• Adult entertainment
• Alcohol
• Civilian firearms
• Gambling
• Tobacco
• Weapons

Controversial Weapons Exclusions

The Portfolio will not invest in any company which, according to the Manager’s methodology, is involved in controversial weapons.

For further details please refer to the Global Sustain Restriction Screening Policy.

Key Characteristics

Strong on engagement: Active portfolio manager-led engagement, including on decarbonisation

Direct and regular portfolio manager-led engagement is a hallmark of our bottom-up approach. Because of our size and long-term holding period, we have excellent access to company management. In 2022, we conducted 152 ESG-related engagements.

Our Global Equity Observer and bi-annual Engage report offer further details on our engagement programme.

Light on carbon: well positioned and resilient for a low carbon transition

The high quality companies we seek are typically naturally carbon-light, benefit from pricing power and resilient demand, and face lower carbon disruption risks than most other companies. Although Global Sustain’ carbon footprint is already 87% lower than MSCI ACWI on a Scope 1 and 2 basis per $m sales (as of 31 December 2022), we have run climate scenario tests measuring transition risk based on carbon tax policies. Our analysis of the estimated impact of a $100 tax per tonne of CO2e on the EBIT of the portfolio’s holdings is -1.2%, versus MSCI ACWI at up to -16% (Scope 1 and 2). Since Global Sustain is significantly less carbon intensive and has higher margins, it has much lower profit sensitivity to carbon pricing. We believe its compounding ability should be preserved even in an environment of tightening carbon policies.

Built on quality: a proven investment team with 25 years’ heritage in quality investing

For over 25 years, the team’s unchanged investment philosophy has been to own high quality compounders, whose value is based on intangible assets. ESG considerations are a fundamental part of the process and are assessed directly by the 14-strong investment team using our ESG scoring framework: the Material Risk Indicator (MRI). The MRI helps to identify material risks and opportunities at company level, consider them in valuation and portfolio construction where appropriate, and identify priority areas for future engagement. Over a quarter century, investing in companies with the fundamentals we prize has delivered attractive long-term returns for our clients and resilience during testing times.

Outcomes

We examine ESG risks and opportunities on a case-by-case basis for the companies we hold, without seeking to meet overall portfolio targets or ratings of external data providers.

As bottom-up investors, we recognise that companies within industries may have different starting points in terms of addressing their specific material ESG challenges and opportunities. To the extent that ESG factors are material for individual stocks in our bottom-up selection process, they play a role in both avoiding material risks and identifying potential return opportunities. Where ESG factors have been identified as material, we look for incremental improvement in the relevant ESG factors.

[1] For the purpose of Global Sustain, the term GHG shall be as defined by the GHG protocol and include carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6) in metric tonnes of CO2 and CO2 equivalent.

[2] Companies with a tie to fossil fuels (thermal coal, oil and gas), in particular reserve ownership, related revenues and power generation.

[3] Utilities (excluding Renewable Electricity and Water Utilities), including any company whose core business activity involves nuclear power generation and /or nuclear power trading.

Process:

Quality Screening of the Investment Universe, Post Exclusions

Post-exclusions, the team follows a clear investment process based on bottom-up stock selection, with sector, industry and stock weightings driven by the team’s assessment of each stock’s quality and valuation characteristics, and any material ESG risks or opportunities they may present.

• Identify high return companies (post exclusions):
  • High unlevered returns on operating capital employed (ROOCE)1
  • High gross margins (pricing power)
  • Capital-light business models driving free cash flow (FCF)2 generation
  • Strong balance sheet

The investment process is based on bottom-up stock selection, beginning with a quantitative screen of the remaining universe to identify high return companies.

We use FactSet Research Systems, a financial database and analytical tool, to screen for various financial characteristics we associate with strong business franchises including high gross margins, high returns on operating capital, low capital expenditure as a percentage of sales, strong balance sheets and the return of cash to shareholders.

We then analyse the sustainability of a company’s returns with an evaluation of franchise quality, management capability and financial strength, together with an assessment of relevant environmental, social and governance factors.

• Make sure returns are sustainable:
  • Ability to remain relevant through powerful intangible assets including brands and networks, sustaining high barriers to entry
  • Returns sustainable against material threats or improvable through material opportunities, including Environmental or Social factors
  • Strong market shares helping to protect against new entrants
  • Stable sales – often repeat business driving recurring revenues
  • Steady organic growth & geographic spread

Franchise Quality: We believe that high quality companies have potential for a sustainable competitive advantage by virtue of their intangible assets, which are generally difficult to re-create or duplicate by competitors. These dominant and durable intangible assets may include strong brand recognition, advertising and promotion, licensing agreements, customer loyalty, patents and networks, copyrights and distribution networks.

ESG considerations are a fundamental and integrated part of the investment and risk assessment process. We explicitly focus on material ESG risks and opportunities and their effect on the sustainability of future returns on operating capital. We use our proprietary ESG scoring framework, the Material Risk Indicator (MRI), as a tool to record portfolio managers’ ESG company assessments in a consistent and comparable way over time. This explicitly documents our evaluation of the ESG factors/risks relevant to the sustainability of returns for our investments. The MRI supplements the existing qualitative and quantitative outputs of our research process.

• Confirm management’s commitment to sustaining returns:
  • Focus on returns on capital rather than sales or EPS growth
  • Capital discipline (reinvest at high returns or return the excess capital to shareholders)
  • Commitment to innovation and investment in franchises
  • Review management incentives
  • Sound Governance structure
  • Engagement on material issues or opportunities where relevant, including ESG factors.

Management Capability: A key characteristic of a compounder relates to the quality and focus of its management. Interviewing management is a valuable part of the research process. Franchise or brand abuse is an important consideration. It is important that management is not distracted from the long-term task of building and improving the company’s intangible assets by the temptation to meet short-term targets. Cuts to advertising and promotion, or research and development budgets, either in absolute terms or as a percentage of sales, can have long-term negative consequences to franchise strength and brand recognition. Compounders enjoy sustainable, high returns on operating capital employed and growth potential, typically generated by a combination of recurring revenues, high gross margins and low capital intensity. This supports strong free cash flow generation which we want to see management reinvest at high rates of return and/or distributed to shareholders.

Direct engagement with companies and boards on material ESG risks and opportunities, and other issues, plays a role in informing us whether management can maintain their high returns on operating capital while growing the business over the long term. Dialogue with companies on engagement topics can be prolonged and require multiple engagements. As long-term shareholders with an owner’s mindset, our active engagement is aligned to our long-term investment approach. In 2022, the team conducted 364 company meetings, of which 152 included discussions on ESG-related topics.

• Valuation:
  • A focus on free cash flow, no accounting numbers
  • FCF yield, DCF, EV/NOPAT3

We then value the stock candidate, seeking to minimise the risk of overpaying.

In our opinion, the most accurate measure of value is on an absolute rather than relative basis.

Our valuation analysis for non-financial companies is rooted in free cash flow analysis. We typically use 10-year Discounted Cashflows (DCFs), cross checked with a variety of multiples, primarily free cash flow yields. Depending on the company and / or industry, we can also triangulate valuation with price earnings ratios and EV/NOPAT (to adjust for leverage, where useful). For more cyclical companies, we can also look at EV/Sales, EV to invested capital and price to book.

We do not adjust the cost of equity in response to government bond yields.

• Portfolio construction (~25 to 50 stocks):
  • Weights influenced by absolute level of risk, the team’s level of conviction, and liquidity, and material ESG considerations
  • 10% max at time of purchase in any one security
  • No country or sector limits. Typical industry limit of 25%
  • Does new idea offer better risk/reward tradeoff?

If the stock is considered a potential candidate for the portfolio, it will be presented at our weekly investment meeting for debate by investors. When a stock is admitted to the portfolio, the weighting is influenced by the absolute level of risk, the team’s level of conviction, its liquidity, and any material ESG considerations.

We regularly engage with management to test our thesis for the long-term sustainability of returns on operating capital and growth potential. Should a material company event occur, we aim to discuss this with management.

• Active ownership:

ONGOING

• Test investment thesis with management
• Direction or returns
• Developing opportunities or threats
• Capital allocation intentions
• Review management activities
• Material ESG developments and direction
• Management changes
• Proxy voting & engagement – not outsourced

EVENT DRIVEN

• Asset materiality with management
• Capital allocation
• What
• Why
• Impact

• Material event
• What
• Why
• Impact
• Fix

We use the same fundamental research to monitor portfolio holdings. This ongoing analysis allows us to update our assumptions regarding existing portfolio holdings to justify their continued inclusion.

This information represents how the investment team generally implements its decision making process under normal market conditions.

Definitions:

ROOCE (Return Operating Capital Employed) = EBITA (Earnings Before Interest, Taxes and Amortization)/PPE (Property, Plant, Equipment) + Trade Working Capital (excludes goodwill). Ex-Financials.

Free cash flow (FCF) = EBITDA + Other cash income - Change in working capital – Cash Restructuring Payments - Pension Deficit Contributions - Interest Paid - Tax Paid - Capex. 

Note: Share Based Compensation is NOT added to the FCF

FCF Yield = FCF / Market Capitalisation

EV = EV = Market Value of Equity + Net Debt + Minorities + Net Pension Liabilities – Financial Investments

NOPAT = Net operating profit after tax.

Data Sources

The team use both proprietary and vendor applications and systems. In particular the team uses FactSet Research Systems, a financial database and analytical tool that allows customised screenings of global companies according to various financial characteristics that may be associated with a strong business franchise.

We may also use ESG reports from ESG data providers as additional points of reference during our research process, including Trucost, Equileap, KnowTheChain, ISS, MSCI ESG and Sustainalytics. As part of our fundamental analysis that seeks to understand the material challenges facing each company, we may reference these research tools to help identify controversies or further assess concerns – ESG or otherwise – that could undermine the long-term sustainability of a company’s returns. We may then, if relevant, discuss them with a company’s management. However, given our very specific investment criteria, research conducted is heavily skewed towards proprietary sources.

As mentioned previously, we use our MRI in the evaluation of ESG factors relevant to the sustainability of returns for our investments.

Resources, Affiliations & Corporate Strategies:

ESG/SRI Resources

The team uses its proprietary ESG scorecard, the Material Risk Indicator (MRI), which aims to identify and assess potentially financially material ESG risks and opportunities facing each company; and the Pay X-Ray (where relevant and possible), which we use as a tool to try to assess whether a company’s pay practices are aligned with management’s intention and/or ability to deliver sustainably high long-term returns on operating capital.

Given our bottom-up fundamental approach to research, in most instances, the main source for our ESG analysis is a company’s own disclosures. Our well-resourced team conducts in-depth analysis of companies, including how potentially financially material ESG issues are approached, drawing on Annual Reports and, where relevant, additional ESG-related reports such as sustainability reports, cyber security reports or human resources-related reports. Our investment team may also engage with the company to further assess potentially financially material ESG issues relevant to companies and to understand their strategies to address these, to monitor progress, and to encourage companies towards better ESG practices where relevant to manage these potentially financially material risks and opportunities.

To support our research, the team may also use vendor applications and systems. In particular, the team uses FactSet Research Systems, a financial database and analytical tool that allows customised screenings of global companies according to various financial characteristics that may be associated with a strong business franchise. We also have access to ESG data and information from third party sources which we may use as additional points of reference during our research process. We have access to a broad set of mainstream ESG data providers including MSCI ESG, ISS, Sustainalytics and Trucost, as well as other more specialised data providers such as Equileap, a comprehensive global database on gender equality. We might also use external research from not-for-profit organisations that assess companies’ performance and management on key ESG issues where such issues are potentially financially material, such as the World Benchmarking Alliance (WBA), Forest 500, ZSL’s company assessment on key commodities such as Palm Oil and KnowTheChain’s assessment of companies’ performance on forced labour in global supply chains.

No single data source is used to make a final investment decision but may contribute to the overall fundamental analysis of the company if considered relevant.

Governance Structure & Responsibilities

Please note SDR specific information will be provided in due course.

Headed by Managing Director and portfolio manager William Lock, the International Equity team manages all aspects of the Fund. The International Equity team is based in Morgan Stanley’s London office.

In addition to the head of the team William Lock, other portfolio managers include Managing Directors Bruno Paulson, Nic Sochovsky, Marcus Watson and Alex Gabriele, and Executive Directors Richard Perrott, Isabelle Mast, Anton Kryachok, Marte Borhaug (Head of ESG) and Vladimir Demine (Head of ESG Research). The International Equity team subscribes to a flat organisational culture; each team member has global sector research responsibilities and participates in investment decisions. The team also includes research analysts Alessandro Vaturi, Bart Dziedzic, Helena Miles, Fei Teng and Jinny Hyun.

To encourage thoughtful discussion and debate there is a high degree of cross coverage and overlapping responsibilities. This also encourages a team-based approach to decision making as all portfolio managers participate in investment decisions. In the unlikely event of a disagreement William Lock has ultimate decision-making authority.

In addition to the bottom-up ESG research conducted by team members, the ESG portfolio managers within the investment team, Marte Borhaug and Vladimir Demine add sustainability expertise and specialist research resources to the investment debate and our engagement with companies, where required. Marte reviews and contributes to ESG strategy for the team, liaises with Morgan Stanley, Morgan Stanley Investment Management (“MSIM”) and external ESG resources, and co-ordinates ESG matters for the team. Vlad focuses on the analysis of thematic financially material ESG topics facing companies in our portfolios.

ESG related affiliations and membership

Through its various businesses and internal functions, MSIM and Morgan Stanley participate in, belong to or take a leading role in many ESG-related initiatives and organisations.

This includes participating in industry conference panels, exploring joint research, and supporting the work of groups focused on ESG-related issues.

MSIM and Morgan Stanley’s external sustainability/ESG-related initiatives and organisations include, but are not limited to, the following:

• UK Investment Association
• Global Impact Investing Network (GIIN)
• ISSB – Sustainability Accounting Standards Board (SASB)
• Ceres Investor Network on Climate Risk and Sustainability
• Irish Funds Industry Association
• Principles for Responsible Investment (PRI)
• International Capital Market Association (ICMA) and the Green & Social Bond Principles (GBP/SBP)
• Emerging Markets Private Equity Association (EMPEA)
• Global Real Estate Sustainability Benchmark (GRESB)
• Japanese Stewardship Code
• Girls Who Invest
• Hong Kong Stewardship Code
• Council for Institutional Investors (CII)
• Institutional Limited Partners Association (ILPA) – Diversity in Action
• One Planet Summit Asset Managers Initiative
• Trading for Trees Program
• Black Women in Asset Management (BWAM)
• Ceres Private Equity Working Group
• European Leveraged Finance Association (ELFA)
• JUST Capital
• 30% Club UK Investor Working Group
• Better Building Partnerships
• Entrepreneurs In Action (EIA)
• PRI Advance (Human Rights)
• PRI – Global Policy Reference Group
• PRI Nature Reference Working Group
• Sponsors for Educational Opportunity – Alternative Investments Fellowship Programme
• UK Stewardship Code
• World Benchmarking Alliance
• CFA Institute’s Diversity, Equity and Inclusion Code
• PRI Collaborative Sovereign Engagement on Climate Change

Dialshifter

This fund is helping to ‘shift the dial from brown to green’ by…

 ...typically investing in intrinsically carbon light companies with an ESG-integrated investment process that offers clients the reassurance that it will maintain a significantly lower carbon footprint than the broader market. In addition, our climate research and climate engagement programme have confirmed our beliefs that the carbon intensity of the Fund’s current holdings is likely to structurally decline even further by 2030 and beyond. 70% of Global Sustain holdings by weight already have long-term net zero and in some cases carbon negative targets. A further 19% have other carbon reduction targets. (Source: Trucost, MSCI ESG Research, MSIM as at 31.12.2021).

Our organisation is helping to support the Paris Climate Agreement and the Race to Net Zero by…

…being one of the 17 global financial firms testing the Paris Agreement Capital Transition Assessment, which enables users to measure the alignment of financial portfolios with climate scenarios. This tool, developed by the 2° Investing Initiative, helps financial institutions understand how their corporate loan portfolios align with the international goals set by the Paris Agreement. Morgan Stanley became the first U.S.-based global bank to join the Partnership for Carbon Accounting Financials (PCAF) and its Steering Committee as part of the firm’s commitment to measuring and disclosing its approach to climate change risk and opportunity.

SDR Labelling: Unlabelled with sustainable characteristics

• Consumer Facing Disclosure