Making an Impact: Environmental, Social, and Governance Investing (ESG)
The more I reflect on my personal investment philosophies, the more I realize how directly my investment approach correlates with being able to sleep at night. This manifests itself in ways such as preferring to invest for periods of at least three years, knowing the stock inside and out so that if it declines I can react rationally, and investing in companies with values and goals I can stand behind. This last idea, investing in companies I’m proud to say I invest in, has become a more prominent value of mine recently and one which has gained a great amount of traction in the investment community in the form of ESG investing and Impact investing.
Therefore, this article will discuss the growing importance, to me personally and to the global financial markets as a whole, of ESG investing, which is the use of environmental, social, and governance factors, in addition to financials, to fundamentally assess the value of a company.
Seeing as ESG is a natural progression of socially responsible investing, which avoids investments in morally questionable industries, ESG investing has been falsely stereotyped as making a tradeoff between ethics and profits. The thinking behind this false dichotomy being that when you reduce the pool of potential investments, you must be missing out on possible returns, therefore reducing your total upside. Over the long-term, however, studies have shown that companies that rate well on relevant ESG factors outperform those that do not while doing so with less volatility (less risk). Another misnomer about ESG strategies is that they are often thought of as secondary to “hardcore” valuation methods. This is an outdated opinion which modern advocates of ESG investing are trying to dismantle as ESG strategies can only be effective when used on equal footing as other strategies.
Quantifying the correlation between ESG factors and financial outperformance is made extremely challenging as most companies do not report certain metrics, nor is there a standard way to report them if they did, so with the hundreds of terms that fall under the umbrella of ESG, there are countless ways to interpret ESG data sets. A new study by Harvard Business School professor George Serafeim, however, attempted to bridge these content gaps and correctly weight different variables to most accurately represent how ESG strategies perform. His work argued that although all ESG factors are important, only a select few have material impacts on the company’s financial success. When correctly weighting the materially relevant ESG factors for various sectors, there was a clear trend that suggested that companies that perform well on materially relevant sustainability issues greatly outperform comparable companies who do not. “Performing well,” in this case, is determined relative to a select peer group of comparable companies. For example, gender diversity, measured as the percentage of women within a company, might be 20%, which seems quite low, but would be ranked very highly because all of the company’s competitors are around 10%. Several other studies support Serafeim’s findings, including reports from Bank of America Merrill Lynch to Morgan Stanley’s Institute for Sustainable Investing.
Therefore, to gain the most practical use of ESG investing, you cannot just take an average of all ESG factors, you must know which factors have the largest material impact on the company you’re looking at, and how those factors compare to a carefully selected peer set. So let’s talk about these factors so you can not only find outperforming companies, but also avoid financial catastrophes.
Environmental - The “E” in ESG stands for environmental issues. I like to think about this by asking myself “how this company is contributing to saving the planet.” This relates to how the company and the company’s products rate on sustainability, clean and renewable energy, carbon emissions, water usage, climate change, public health issues, etc. It is fully possible however, that companies may sacrifice one value to progress another, such as polluting more while in the process of achieving sustainable energy. This situation is also not ideal.
Social - The “S” in ESG stands for social issues. I like to think of this as whether or not this company’s culture is beneficial to its employees. This relates to how the company and the company’s products incorporate or promote diversity, employee benefits/pay/safety, flexibility, support, engagement levels, the company’s mission, values, decrease employee churn rates, etc. Intuitively, companies that trust and support their employees, have increased diversity, and offer increased flexibility for better work life balances ultimately see that their employees are happier, healthier and more productive, therefore helping the bottom line.
Governance - The “G” in ESG stands for governance, specifically corporate governance. I think of this as fully understanding the board of directors and its structure. This could include board incentive structures, management structures, long-term focused compensation practices, board composition (diversity, experience), voting procedures, etc. I had invested in Sketchers back in late September of 2017 and one of my core investment theses was that management would stick to their goals of substantially expanding margins. The rest of the market picked up on this thesis as well, sending the stock up over 50% in five months. The stock plummeted however, when management said they were abandoning their efforts to expand margins to increase top line growth, sending the stock down 30%. This could have easily been predicted had I realized that the bonuses of upper management were based solely on top line growth, therefore removing any incentive to carry out their margin expansion plans. Lesson learned.
Okay, but how do you measure ESG factors? How can you measure sustainability? Or culture? Or put a price on the gender diversity of a company? This challenging task is the beauty of ESG funds. ESG investing is actually far more data driven than one might think, as their sole goal is to quantify the unquantifiable. My favorite example of how this can be achieved is analyzing Glassdoor data to assess the health of a company’s culture. This could include valuing topics including the overall ratings of the company, the employee’s approval of the CEO, or even the collective opinion on the dress code. From there, you might weight various people’s opinions differently based on their status within the firm, which region they operate within, or the length of time they’ve been at the firm. The ultimate goal being to assess how motivated or supported a company’s employees feel to assess higher productivity and innovation and therefore financial outperformance.
For example, the Glassdoor reviews of Wells Fargo clearly exemplified several red flags regarding astronomical sales goals. At first they were seen as a significant negative due to the toxic work environment they created which resulted in fraud, but now that these sales goals have been removed altogether, employees openly report feeling demotivated and aimless. But not only can this data signal problems, it can also easily signal the opposite for companies with good cultures. When people feel psychologically safe within an organization, they can learn, grow, and contribute to a company who’s unified vision achieves something greater than themselves. Why wouldn’t you want to invest in that?
So we’ve established that there is an emerging field of data that suggests that when correctly weighting materially relevant ESG factors, companies that do well on said factors massively outperform those that don’t and do so with less risk. ESG companies have good cultures, a clear vision to positively impact the world, and a strong management team that is incentivized in healthy ways to achieve that vision. We’ve also covered that although ESG strategies will help you sleep at night, they are far from what was once thought of as a “soft” field.
Even if you still aren’t convinced of the opportunities ESG investing can offer to a diversified portfolio, the massive ESG trend cannot be ignored. Morgan Stanley's Institute for Sustainable Investing conducted a study in 2017 on the connection between millenials and ESG investing, revealing that "86% of millennials are interested in sustainable investing, or investing in companies or funds that aim to generate market-rate financial returns, while pursuing positive social and/or environmental impact.” They also found that millennials are “twice as likely as the overall investor population to invest in companies targeting social or environmental goals. And 90% of them say they want sustainable investing as an option within their 401(k) plans." This matters immensely because millenials are about to inherit an unprecedented $30 trillion from baby boomers over the course of the next few decades. Bank of America Merrill Lynch predicted that in the next 20 to 30 years, millennials could pour between $15 trillion and $20 trillion into ESG investments in the US alone. This means that in addition to the positives I have already attributed to ESG investing, there will also be a positive tailwind to all ESG companies as more and more capital is allocated to ESG funds.
One word of warning however: in my research I’ve found that there are a lot of companies and funds (be that ETFs or Hedge funds) that mislead consumers into thinking they are ESG friendly when they are not, simply to attract more capital. This means that when a company or fund is discovered to be unethical or non ESG friendly, the stock or fund will drop in value significantly as capital is reallocated.
In conclusion, ESG is a fascinating new field that has a watered down stereotype due to the general confusion over its relevance in determining true value, but as more data emerges and companies start to report ESG metrics on a more standardized basis, I firmly believe a positive trend between ESG positive metrics and financial outperformance will emerge.
(My source of inspiration for this post was Patrick O'Shaughnessy’s Invest Like the Best podcast episode entitled “Katherine Collins - Impact and ESG Investing - Invest Like the Best.” I would highly recommend listening to it if you get the chance!)
Continue the conversation with James at jem365@georgetown.edu.