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Why Are Primecap Funds So Sustainable?

These Gold-rated funds have Morningstar Sustainability Ratings of High despite not explicitly trying to do so.

The Morningstar Sustainability Rating for funds, which we introduced in March, helps investors measure how sustainable a mutual fund's portfolio is--that is, how well the companies it owns are handling the various environmental, social, and governance (ESG) issues they face. Research firm Sustainalytics first looks at company-level ESG factors such as environmental and workplace policies, product safety, and corporate responsibility, combining these into an ESG score for each company. Penalties are assessed for any ESG-related controversies, ranging from minor issues to major problems such as Volkswagen's recent emissions scandal. The resulting Sustainability Scores are rolled up on an asset-weighted basis to calculate a Portfolio Sustainability Score, and funds are ranked against their Morningstar Category peers. Funds with a Sustainability Rating of High (represented by 5 globes) have holdings that collectively score very well on ESG factors, while funds with lower scores earn lower ratings, down to Low (represented by 1 globe).

One useful feature of this rating is the fact that it's assigned to all funds, not just those that are marketed as socially responsible or ESG-oriented. Not surprisingly, funds that commit themselves to sustainability as part of their mandate do tend to have high Sustainability Ratings, with 80% earning ratings of Above Average or High. But there are also plenty of funds that earn high ratings even though they don't explicitly aim for such a result. We took a look at some such funds recently in a survey of Morningstar Medalists that also earn 5-globe Sustainability Ratings and in a survey of medalists in the large-growth category with the highest and lowest sustainability ratings.

To get a better idea of why these funds have such high Sustainability Ratings, it's worth taking a closer look at some of them and drilling down into their portfolios. Consider the Primecap funds, four of which-- Vanguard Primecap (VPMCX),  Vanguard Primecap Core (VPCCX),  Vanguard Capital Opportunity (VHCOX), and  Primecap Odyssey Growth (POGRX)--are the only large-growth funds to combine a Morningstar Analyst Rating of Gold and a Morningstar Sustainability Rating of High. (The same is true of the large-blend  Primecap Odyssey Stock (POSKX) and the mid-cap growth  Primecap Odyssey Aggressive Growth (POAGX).) All of these funds are run by the same team of five portfolio managers, using variations of the same basic contrarian growth strategy. The managers say they don't explicitly incorporate ESG factors into their stock-picking, though they do think that the best stocks are often those that add value to society. Their long-term perspective and emphasis on stable growers also tend to favor stocks that score well in sustainability.

A good example is the biotech and big pharma firms that have been prominent in all the Primecap portfolios for years. Many of these earn good Sustainability Scores because they have a positive impact on society (helping cure diseases), and they tend not to have many problems with environmental or social issues.  Biogen (BIIB), which is the top holding in Vanguard Primecap and Vanguard Capital Opportunity and a top-10 holding in Vanguard Primecap Core and Primecap Odyssey Growth, has a Sustainability Score above 70, putting it in the top 3% of all companies. (The scores are normalized so that 50 is average, and all but a handful of companies have scores between 30 and 70.) Biogen scores well on ESG measures and has no significant controversies to hurt its score.  Novartis (NVS) and Roche, two other prominent healthcare holdings across the Primecap funds, also have relatively high scores, even after being penalized for moderate controversies. Other biotech and pharma names found in most of the funds, such as  Amgen (AMGN) and  Eli Lilly (LLY), score closer to average on sustainability, but none score significantly below average.

Technology is the other sector in which all the Primecap funds are relatively heavy, and here, too, several of the funds' top holdings score very well on sustainability.  Adobe Systems (ADBE) and  Texas Instruments (TXN), both top-10 holdings in Vanguard Primecap that are also prominently featured in several of the team's other funds, stand out with Sustainability Scores above 60, putting them among the top 20% of all companies. Such big tech names as  Microsoft (MSFT),  Intel (INTC), and  Cisco (CSCO) also have above-average Sustainability Scores and are held by most of the Primecap funds, with Microsoft being in the top 10 of four of them. These are all well-established tech names, profitable and stable, in keeping with the Primecap approach to stock-picking. On the other hand, Internet-focused companies often score lower on sustainability, but they tend not to be the types of stocks the Primecap managers like.  Facebook (FB),  Amazon (AMZN),  Priceline (PCLN), and  Yahoo (YHOO) all have Sustainability Scores below 40, putting them in the bottom 20%, but none has a significant presence in the Primecap portfolios; Facebook and Priceline are not held by any of the funds, while a couple of the funds have very small positions in Amazon and Yahoo (under 0.5% of assets).  Alphabet (GOOG) (formerly Google) is a significant holding in all the funds, and a top-10 holding in Vanguard Primecap, but it scores just about average on sustainability, better than the other four firms just mentioned.

The Primecap funds are often helped on the sustainability front by what they don't own. For example, none of the funds has more than a tiny percentage of its portfolio in energy or materials companies, many of which have low or mediocre Sustainability Scores. That doesn't mean that these funds hold no firms with very low Sustainability Scores; Chinese Internet firm  Alibaba (BABA), held in five of the funds and a top-20 holding in Vanguard Primecap, has a score below 30, as does  Monsanto (MON), a top-25 holding in Vanguard Primecap and Vanguard Capital Opportunity. The managers are also fans of  JPMorgan Chase (JPM) despite losses and legal fallout from the "London Whale" scandal, which drags down that firm's score.

However, such examples are few and far between in these funds. In general, the Primecap managers tend to like companies that have a positive impact on the world and avoid serious ethical problems, in addition to looking like good long-term investments. Many ESG fund managers argue that those two features are explicitly connected, but the Primecap funds show that it's not necessary to have an intentional ESG or sustainability focus to invest in a way that results in a responsible outcome for investors.

David Kathman has a position in the following securities mentioned above: VPMCX. Find out about Morningstar’s editorial policies.