Environmental and human rights concerns remain a risk for the fashion and apparel industry. However, in recent times producers have generally managed these risks well, for example by securing alternative sources of supply. Most companies, with the exception of fast fashion brands, are assigned a low ESG risk rating by Sustainalytics (the threshold for a medium ESG risk rating is a score above 20).
Morningstar’s new report “Clothing and Fashion: Environmental and human rights concerns abound, but risk-adjusted upside looks attractive” identifies several undervalued stocks in the fashion sector – across the spectrum of mass-market, luxury and retail apparel businesses. Some of the top picks include Narrow Moat Hanesbrands (HBI), Wide Moat Richemont (CFRHF), and Moatless Gap (GPS).
Clothing manufacturers: environmental risks
The clothing industry is one of the biggest polluters in the world. On the one hand, fabric production accounts for 10% of annual global carbon emissions. The fast fashion trend adds further pressure as these garments tend to use more synthetic fibers like polyester or polyamide which are CO2 intensive to produce. In response to this, fast fashion leaders have tried to build more sustainable supply bases and set targets for the use of recycled materials. H&M, for example, is aiming for 30% recycled materials in its range by 2025, up from 18% in 2021.
Water is another big concern in the manufacturing segment, both in terms of water usage and wastage. Around 20% of the world’s wastewater comes from the dyeing and processing of fabrics, while textiles contribute 35% of microplastic pollution in the oceans.
As pressure mounts from regulators and the general public to lessen the environmental footprint of industrial activity, fast fashion companies are also increasingly exposed to regulatory risks. The EU, for example, proposes requirements for increased durability, a reduction in the release of microplastics when washing clothes, labeling related to the durability and recyclability of clothes, and a ban on the destruction of unsold clothes. .
Due to the combination of these factors, costs are expected to increase and some companies are better positioned than others to meet higher production expenses. “In our view, companies with economic moats of brand-driven intangibles, resulting pricing power, and potential volume leverage are best placed to share the pain with their customers. suppliers to deal with this risk. This is about two-thirds of our relevant clothing coverage, including several wide-ditch names outside of the fast fashion arena such as Richemont, Hermès, LVMH and Nike,” says Adam Fleck, CFA, Director of ESG Equity Research, who authored the study.
Modern slavery and garment manufacturing
Human rights and modern slavery continue to plague the fashion industry, despite the focus on eradicating the practice in recent years.
Often making headlines, human rights issues are actually the most significant risk facing apparel companies, according to Sustainalytics. While this primarily relates to supply chains and not company-owned facilities, much of the reputational risk falls on the companies whose brands are on a label. Of the 36 companies covered by Morningstar in apparel, luxury goods, footwear and retail, 25 have faced human rights controversy.
The exposure of global brands to exploitative wages and forced labor has affected production in developing countries like Haiti and Bangladesh. More recently, China’s treatment of the Uyghur population in the Xinjiang region has resulted in tit-for-tat boycotts that have hit sales of Western brands in the country. China accounts for about 25% of global cotton production, and about 80% of that amount comes from Xinjiang.
In response, the United States introduced the Uyghur Forced Labor Prevention Act. The European Commission is preparing to propose an instrument to combat forced labor in the EU. The regulation aims to punish companies that do not have full transparency over their supply chains, increasing the importance of audits and oversight.
“While we expect businesses to be able to manage these risks over the long term, we expect short-term volatility in costs and supplier relationships to persist,” concludes Fleck.
Luxury sector: Risk of counterfeits
In general, luxury brands face low ESG risks, and almost all of the companies in our coverage – except Burberry – have a low ESG risk rating.
However, the trend of buying and reselling online, on marketplaces such as Poshmark or The RealReal, could bring new risks linked to counterfeits. According to an OECD study, trade in counterfeit and pirated goods accounted for 2.5% of global trade in 2019.
In response, companies such as LVMH, Prada and Richemont are turning to blockchain technology to authenticate products. Similarly, online marketplaces are also investing in their own internal authentication services. The main weakness of these efforts is that a large proportion of counterfeits are purchased intentionally.
Top Stock Picks
Companies with strong economic moats are best positioned to navigate this environment. Here’s a rundown of our top picks.