Global companies’ performance on environmental, social, and governance (ESG) issues is rapidly becoming more critical to their competitiveness, profitability and share price. We are writing this commentary and re-orienting our own investment philosophy, because we profoundly care about environmental issues. We can also get onboard with the social and governance aspects of ESG investing because, as explained below, managers focusing on these issues will necessarily be positioning their companies for long-term value creation. ESG investing, also referred to as sustainable investing, will become a dominant investor theme of the 21st century, we believe. Integrating ESG in your investing can reduce portfolio risk, generate competitive investment returns, and help investors feel good about the stocks they own.
Why ESG Matters For You As An Investor
ESG is a stakeholder-centric theory, meaning that how companies treat all their stakeholders will impact their long-term success or failure. Companies focused on ESG will both minimize risks to their business and operate more efficiently. In terms of environment, for example, a forestry company committed to planting more trees each year than it cuts down will obviously be creating a more sustainable business. As for the social element, it stands to reason that unhappy, unhealthy, or stressed employees won’t be eager brand ambassadors, willing to provide excellent customer service, or innovate for the company. Similarly, companies with poor diversity across its workforce, management teams, and boardroom lose out on intellectual capital and valuable perspectives.
Managers who are attentive to ESG factors are necessarily engaging in long-term thinking. We can surmise that there is a corollary between strong ESG traits and companies with exemplary management teams. We know that CEOs who chase short-term quarterly profits most often do so at the expense of creating long-term firm value.
Like everything in the markets, it comes down to supply and demand. ESG is no exception. Morgan Stanley’s Institute for Sustainable Investing studied the link between millennials and sustainable investing. Consider the following:
In 2017, Morgan Stanley’s survey of active individual investors revealed 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. 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.
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 U.S.
Unlike Baby Boomers, Millennials have grown up in a world of “political correctness”. Environment and social issues resonate with Millennials. Millennials consistently show a tendency to crave social responsibility, whether it’s in the products they purchase, the organizations they work for, or their investment portfolios. We predict, as Millennials increase their earnings and savings, and replace Baby Boomers in terms of contributors of investment dollars to the market, that a sustainability premium will be priced into company stock prices. That is, the preference of Millennials for ESG-focused companies will increase long-term demand for their shares.
And as Millennials have more and more money to invest, growth in ESG assets will continue to increase at a rapid pace. Just how rapid? Check out this chart from the Financial Times showing that investments in ESG funds have increased five-fold since 2017. This trend will not slow.
Yet another reason that readers are well-advised to concentrate their portfolios on ESG-focused firms is the correlation between firm managers attentive to sustainability issues and earnings volatility. The following chart by Bank of America is revealing.
ESG-focused firms tend to display lower earnings risk. We surmise that the Product Responsibility criteria (see below) within the ESG standards coincide with less volatility in earnings.
Additionally, we have also come across anecdotal evidence that 90% of bankruptcies have occurred in companies with low ESG scores. The logic is solid. Managers concerned with long-term sustainability issues necessarily are making better long-term business decisions for the company.
Finally, a Bank of America report showed that the highest-scoring ESG companies tend to have cheaper access to capital. A lower cost of capital translates into stronger bottom-line earnings.
We use the Thomson Reuters ESG score calculations as Thomson Reuters is one of the best, most reliable sources of financial data in the world. Note that other sources, such as Bloomberg, MSCI, and even Yahoo Finance (free), also provide Sustainability data on companies and that each source’s scoring of a company will differ. ESG Scores are calculated from company data published annually in the company’s Sustainability Reports (CSR).
In the case of Thomson Reuters, this data distributor collects over 400 data criteria which are grouped into 10 categories across the three ESG pillars. As an example, referring to the image below, there are 19 Resource Use measures under the Environmental pillar (see below) which contribute 11% to the overall ESG score.
We summarize below the input data used in calculating ESG scores.
Environmental Pillar Score
The Environmental Pillar Score measures a company’s impact on living and non-living natural systems, including the air, land, and water ecosystems. This score reflects how well a company uses best management practices to avoid environmental risks and capitalize on environmental opportunities in order to generate long-term shareholder value. This score is divided into three groups:
- The Resource Use Score reflects a company’s performance and capacity to reduce the use of materials, energy or water, and to find more eco-efficient solutions by improving supply chain management.
- The Emission Reduction Score measures a company’s commitment and effectiveness towards reducing environmental emissions in the production and operational processes.
- The Innovation Score reflects a company’s capacity to reduce the environmental costs and burdens for its customers, thereby creating new market opportunities through new environmental technologies and processes or eco-designed products.
Note that a company ESG score considers all three categories (environmental, social, and governance). For us, and this is completely subjective, the environmental score is the most important. Preserving the planet for both the current occupants as well as future generations is the most basic and essential thing that we need to do collectively as a society. Global warming is real. The disappearance of glaciers in the Alps is accelerating at an alarming pace. Deforestation is both an ignorant and irresponsible act of man. Factory and auto emissions are leaving humans with blackened lungs from breathing these particles and destroying the ozone layer.
While companies are the largest polluters, hence the importance of the accountability brought by the ESG scores, each person reading this article should be “chipping in” to preserve our planet. Do you have to take the plane for business? Then compensate for your CO2 footprint by taking your bike or public transport to work. Your town does not have curb side recycling (as in our case in Hilton Head)? Get a recycling box or bag, sort your waste, and driving your recyclables to the local recycling center. The production of meat for human consumption leaves a huge CO2 footprint. Why not cut back meat consumption to one or two meals per week? Companies like Beyond Meat (BYND) and Impossible Foods (an upcoming IPO that we will be getting into) are offering excellent plant-based protein alternatives. Finally, as investors, why not build your portfolio around environmentally responsible companies with high Environment Pillar ESG scores? Here are some examples of Environment Pillar measures:
- Resource Use
- Water Efficiency (Water Recycled, Water Technologies)
- Energy Efficiency (Renewable Energy Purchased
- Green Buildings
- Toxic Chemicals Reduction
- Environmental Supply Chain Management
- CO2, NOx and Sox
- Ozone-Depleting Substances
- Hazardous Waste
- Waste Reduction Initiatives
- Environmental Products
- Eco-Design Products
- Noise Reduction
- Hybrid Vehicles
- Animal Testing
- Take-back and Recycling Initiatives
- Sustainable Packaging
Social Pillar Score
The Social Pillar Score is comprised of four subcategories:
- The Workforce Score measures a company’s effectiveness towards job satisfaction, a healthy and safe workplace, maintaining diversity and equal opportunities and development opportunities for its workforce.
- The Human Rights Score measures a company’s effectiveness towards respecting the fundamental human rights conventions.
- The Community Score measures the company’s commitment towards being a good citizen, protecting public health and respecting business ethics.
- The Product Responsibility Score reflects a company’s capacity to produce quality goods and services integrating the customer’s health and safety, integrity and data privacy.
Again, the calculation of the Social portion of the ESG score is a composite of many criteria. Here are a few examples:
- Health & Safety Policy
- Targets Diversity and Opportunity
- Employee Satisfaction
- Salary Gap
- Announced Layoffs
- Women Managers
- Total Injury Rate
- Average Training Hours
- Internal Promotion
- Human Rights
- Policy Child Labor
- Ethical Trading Initiative ETI
- Policy Fair Competition
- Bribery, Corruption and Fraud Controversies
- Corporate Responsibility Awards
- Crisis Management Systems
- Product Responsibility
- ISO 9000
- Six Sigma and Quality Mgt Systems
- Product Recall
- Alcohol, Gambling, Tobacco, Firearms, Pornography
- Consumer Complaints Controversies
Governance Pillar Score
The Governance Pillar Score is derived from three sub-scores:
- The Management Score measures a company’s commitment and effectiveness towards following best practice corporate governance principles.
- The Shareholders Score measures a company’s effectiveness towards equal treatment of shareholders and the use of anti-takeover devices.
- The CSR Strategy Score reflects a company’s practices to communicate that it integrates the economic (financial), social and environmental dimensions into its day-to-day decision-making processes.
Here is a non-exhaustive list of Governance measures used in the ESG Score calculation:
- Policy Board Independence / Diversity / Experience
- Internal Audit Department Reporting
- Succession Plan
- External Consultants
- CEO-Chairman Separation
- Independent Board Members
- Executive Compensation Policy
- Shareholder Rights Policy
- Shareholder Vote on Executive Pay
- Staggered Board Structure
- Supermajority Vote Requirement
- CSR Strategy
- CSR Sustainability Committee
- CSR Sustainability Reporting
Initiated readers may have heard of ESG Controversies. The ESG Controversies Score measures a company’s exposure to environmental, social, and governance controversies and negative events reflected in the global media. Examples would be suspicious social behavior (Altria (NYSE:MO) and vaping) and product-harm scandals (Purdue Pharmaceuticals) that place the firm under the media spotlight. Controversies would seem to be important for firm value, as this kind of news raises doubts about the firm’s future prospects. However, some early research suggests that controversies do not negatively impact firm value. The current literature on ESG Controversies may lack sufficient historical data to draw more robust conclusions. Moreover, the time horizon needs to be studied – do negative ESG headlines hurt firm value just in the short-run?
The ambiguity of ESG Controversies on firm valuation aside, we prefer not to invest in companies in the negative media spotlight for a simple reason. If firm management does not recognize, in the 21st century, what is at stake in terms of environmental stewardship and social responsibility, and is moreover unable to steer their company away from these controversies, we don’t have confidence in management to give them our investment dollars.
A poor ESG Controversies score should not necessarily preclude conscious-minded investors from including a company in their portfolio. But investors should take note and research why the company is getting bad press.
A recent example of an ESG-compliant company that, nevertheless, found the negative media spotlight is Johnson & Johnson (NYSE:JNJ).
The reason J&J receives a “D-” for the ESG Controversies grade is obviously the role of the company in fueling the opioid addiction crisis. ESG-concerned investors would need to decide if they are comfortable supporting Johnson & Johnson.
ESG Is Not Exactly SRI
ESG and Socially Responsible Investing (SRI) both focus on investing in publicly traded companies. On one hand, ESG investors actively opt into companies because of impressive environmental, social, and governance attributes that they have demonstrated. The ESG approach researches the nuts and bolts of how a company is managed, then quantifies the results. On the other hand, a traditional SRI investor focuses on excluding certain industries or companies because they don’t meet their particular value criteria. Investments typically excluded in an SRI framework include tobacco, alcohol, gambling, and weapons stocks.
It is worth noting that a “repulsive” industry can yield a high-ESG company. For example, Altria produces the majority of its revenue from tobacco sales. Yet Altria scores high on environmental sustainability, employee treatment, corporate governance, and diversity, therefore meriting inclusion in ESG benchmarked funds, even though Altria would be anathema for a traditional SRI investor.
Our strategy portfolios meet strict ESG selection criteria. But in addition to this, our investors, like us, don’t want to support companies working against our social values. As such, in addition to running ESG-focused portfolios, we overlay our selection with some traditional SRI exclusion criteria. Notably, we will not consider for investment any tobacco companies, firearms/weapons makers, and certain drug companies known for price-gouging tactics (an example is Mylan (NASDAQ:MYL)).
When we invest money in a company, we are voting with our dollars. In good conscious, we cannot support the behavior of a company like Altria, where firm managers come to the office each day with the objective of going right up to the limit, both in terms of what regulators will admit and what our society would find too indecent in marketing their crap to the public.
An Actively Managed ESG Strategy
Readers who have gotten this far should be (we hope) convinced by our argument in favor of ESG investing. Like for every other investment theme, a reader might want to turn to an ETF. And there do exist ETFs on ESG investing, such as the MSCI USA ESG Select ETF (SUSA). We strongly recommend against resorting to an ETF, if you chose to invest in accordance with ESG principles.
An ETF is a hodgepodge of companies thrown together and marketed to the public. As an investor, it’s important to do your homework on the methods a fund uses, and whether they screen out certain industries. ESG ETFs still invest in “sin” stocks, such as alcohol, tobacco and firearms companies. This may not be what an ESG-concerned investor wants.
Kitchen sink ESG ETFs also invest in as many companies meeting a low threshold of ESG standards. The SUSA fund, for example, invests in a portfolio of 126 companies. Readers must ask themselves if this is a rigorous selection process. We think not.
Another problem with taking the kitchen sink approach to an ESG fund (throwing in all companies that might pass as ESG) is that fund performance boils down to that of the broad market. The following chart is telling. There are two lines plotted from 2010 – the S&P 500 index and the S&P 500 ESG index. Yes, there are two lines, even if it is hard to tell.
We would explain this lack of divergence by two causes.
First, the folks at S&P Dow Jones index wanted to build an S&P 500 ESG index closely aligned with the regular S&P 500 in terms of industry weightings. In reading about their selection methodology, S&P Dow Jones only excludes the bottom 25% of companies by ESG score in each GICS industry group. This is hardly a proactive vote in favor of companies strongly adhering to ESG values.
Second, just buying ESG-focused companies is not a sufficient condition for an outperforming portfolio. The company must still be growing earnings and revenue, and investors must assure that companies they choose offer attractive valuations for long-term price appreciation of shares. For this reason, our Top Picks selection committee has a duel mandate: we want companies with both very strong ESG traits and high scores within the WMA fundamental rankings.
By having ESG inside our investment processes, we can make better-informed investment decisions that support our mission to achieve the best possible risk-adjusted returns for our investors. By factoring in all ESG and company fundamentals that impact company strategy and outlook, we believe that we get a clearer view on whether a company is being managed effectively or likely to generate long-term returns.
Bottom line: Passive investing in ESG indexes is NOT the solution for investors sensitive to the ESG investment theme. We believe that a portfolio needs to be actively managed in general. And all the more so with ESG investing. Market conditions change. Company earnings outlooks are not static. New management may lose focus on ESG values. Stock valuations and balance sheets need to be considered. At any given moment in the market, there are “good” ESG-focused companies and “bad” ESG-focused companies. Our job as ESG-oriented investment managers is to ensure that our portfolios remain invested in only the good companies.
If you agree with the importance of Environmentally and Socially Responsible investing for the long-term, click on the “Follow” button next to the title of this article above. Bill and Owen will be writing regular articles advocating investments in high potential, ESG-focused companies.
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