Industry Voice: Is it best to divest? The case against ex ante exclusion

How did Volkswagen go from greenwashing in 2015 to issuing green bonds in 2021? And what did it mean for investors? Read the case study to learn more about the power of fundamental analysis and the role of third-party ratings.

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Industry Voice: Is it best to divest? The case against ex ante exclusion

In 2015, Volkswagen was branded with a Clean Air Act violation after emissions violations and poor governance practices were unearthed.

The scandal initially progressed as follows:

  • VW was the focus of widespread investor and consumer concern, along with impaired valuations compared to its original equipment manufacturer (OEM) peers.
  • The company was given the lowest ESG rating by MSCI (CCC),1 determining it uninvestable under third-party rating criteria.
  • VW chose to leave the United Nations Global Compact (UNGC) — a UN pact to encourage businesses to adopt sustainable and socially responsible policies and practices — following "Dieselgate," subjecting it to further exclusion.
  • MFS' team took a negative view of the company, which is one reason they downgraded their rating.

While the Volkswagen case raised concerns for MFS, they also recognized that wider spreads caused by the scandal presented an opportunity to enhance returns for investors.

VW makes up a significant part of the automation sector and Euro Corporate Bond Index, and excluding it could constrain MFS's ability to outperform the benchmark for their clients. MFS believes a combination of traditional credit analysis alongside ESG considerations and thorough engagement reveals relative value opportunities. Critical to this analysis is a sound understanding of the company's strategic path forward. When seeking to drive returns and effectively manage risk, understanding whether VW would be able to remain relevant and generate cash flows over the long term was critical.

The road to recovery

After tracing the company's recovery efforts over the past few years, MFS has begun to take a more positive view.

Environmental leadership

  • The company committed to a low-carbon transition and was early to set some of highest electrification targets in the industry.
  • VW issued €3 billion in green bonds in 2021 to "refinance" existing projects related to its production of battery-electric vehicles.
  • The company has planned for an ambitious 30% reduction in CO2 by 2025, and carbon neutrality by 2050.
  • Following the VW's departure from the UNGC, the compact's founder was hired by the company to lead its reformed ESG strategy.
  • In February 2021, VW announced its reinstatement in the UNGC.

Over time, these observations have positively reinforced MFS' investment thesis, and their view has now changed. Their fundamental analysis revealed that VW's environmental strategy is the most comprehensive within its sector. They believe its renewed commitment to sustainability potentially enhances its reputation may increase its resilience in the marketplace over the long term.

Rethinking corporate governance

Some of VW's greatest conflicts have been internal and governance-related due to family and state ownership, lack of independence and the long-term nature of board membership. MFS' research has revealed that company leadership is aware of its governance issues and has recently introduced management changes across all divisions in 2020 as board members sought to shake off a reputation tarnished by Dieselgate. MFS expects to see governance concerns gradually easing as strategic reform based on sound ESG principles gains traction.

What about consumers?

Dieselgate appears to have impacted investors more than consumers, with VW's reputational risk having less impact on unit sales and free cash flow. In MFS' view, free cash flow is one of the strongest indicators of the health of a company. Exhibit 1 shows how despite the scandal, VW's sales remained steady and its free cash flow generation reverted to strong positive flows after the company paid billions in fines…



This post was funded by MFS

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