ESG Investing – The Basics
ESG investing is fundamentally a framework for making value-based investments. As the acronym suggests, “ESG” refers to a triad of factors used to evaluate corporate practices of an organization.
- Environmental – is the organization a quality steward of the environment? Do their practices consider natural resource efficiency and conservation?
- Social – how does the organization treat its own people and its customers. Does it make a positive impact on its immediate community and beyond? Labor standards and
- Governance – how does the organization operate at the highest level? Executive compensation, board composition, business ethics, and political contributions or relationships may all come into focus.
The ESG framework is usually used in the context of publicly held companies and their traded stocks. However, there is nothing to stop an investor from using the framework to assess other kinds of assets (e.g. private real estate investments, pre-IPO startup/“equity crowdfunding,” or municipal bonds.)
ESG investing is similar in intent to the SRI (socially responsible investing) framework, but aligns more closely with value investing. Generally, SRI investing seeks to exclude offending companies and assets from a given portfolio. ESG investing, rather, seeks to identify companies making positive impact and pursue investment into companies and other assets that not only reflect progressive impact in these three areas, but also realize competitive advantage through these practices.
Why Pursue ESG Investments?
Because you aren’t an asshole. Let’s start there. Petroleum, livestock, and big agra companies are ruining the planet. Weapon manufacturers and cigarette producers kill people. Uber and various other tech companies allow endemic misogyny and HR nightmares to go unaddressed. And so forth. Buying shares of these companies is both implicitly and materially supporting them. So… consider not doing that.
Lots of companies have evolved beyond the Gordon Geckensian notion that profit reigns supreme over all other imperatives in the private sphere. Prominent CEOs have adopted the radical idea that maximizing shareholder value is not their only reason for being. The fact that pundits, investors and some companies still operate as though shareholder value is the only thing that matters constitutes a market inefficiency, and opportunity for outperforming benchmarks. In other words, not only can ESG investing serve as a means of not being an asshole, it can also be a winning investment strategy from a pure returns standpoint.
How and Why ESG Investments Can Outperform
A number of studies show that high ESG standards correlate with improved corporate financial performance. Proving causality has been more challenging (do companies outperform because of high ESG standards, or do they invest in improved ESG standards because they can due to healthy corporate financial performance?)
Several recent studies have sought to better understand this relationship, and robust studies in recent years show evidence that improving ESG standards serves as a leading indicator for improving corporate financial performance.
The Journal of Portfolio Management’s extensive 2019 study shows that ESG values “transmit” to improved financial results through three channels:
The Cash Flow Channel
- Companies with strong ESG profiles are more resource efficient, better at developing and retaining human capital, and are better at fostering and managing innovation.
- These competitive advantages generate persistently higher and more reliable net operating income.
- Better dividends to shareholders result from stronger profitability.
The Idiosyncratic Risk Channel
Idiosyncratic risk is risk specific to a company and its operations (expressed as volatility with respect to share price) – as opposed to “systemic” risk which refers to risk inherent in the entire financial system or an entire sector of the economy.
Companies with strong ESG standards (particularly in the ‘governance’ category) typically evince better risk control standards. In other words, because companies like Facebook and Uber are run by petulant, quasi-human manbabies (whose shortcomings filter down through senior leadership) such companies are more prone to scandals and blind spots that create more volatility and stock-specific risk over time.
The Valuation Channel
Companies with high ESG standards – particularly in the ‘environment’ category – have been shown, on average, to be less susceptible to systemic risk. For example, a more energy-efficient company will be less vulnerable to fluctuations in energy prices. A multinational with a more sustainable “on-shored” supply chain and less reliance on cheap foreign labor will be less vulnerable to the impact of trade tensions, political upheaval, or other global economic shocks.
These efficiencies allow companies with higher ESG standards to generally capture lower cost of capital, yielding higher valuations over time on average.
Recent studies have also shown that improvements in ESG practices serve as a leading indicator for corporate financial performance; improved stock performance follows improvements to ESG standards, on average. This means that by investing in companies who are currently investing in ESG practices, investors can potentially realize superior returns and find alpha.
“The authors used MSCI ESG Ratings data to create customized ESG scores and performed a regression analysis of stock returns to ESG score changes (i.e., ESG momentum), neutralized with respect to changes in size, market-to-book ratio, leverage, profitability, R&D intensity, advertising intensity, institutional ownership, and sector membership. The authors found statistically significant predictive power of ESG momentum for stock returns.”
Neoclassical economic theory (espoused by such taxidermied walruses as Milton Friedman) holds that sustainability investments unnecessarily raise a firm’s costs and create a competitive disadvantage. At best, they yield managerial benefits while hurting shareholder value. Others have poo pooed ESG investment as a system of political beliefs… which is a dumbass opinion when you think about it – arguing that ESG investing is politically motivated is itself a political belief.
In short, ESG practices may constitute a means of doing business more efficiently and sustainably. These principles may also help companies better retain employees and customers. A review of the recent literature suggests that these benefits do indeed translate to better stock performance.
Who Determines ESG Ratings?
Excellent query. While the framework is broadly accepted by analytics firms and NGOs, there is no one authoritative source of truth for how ESG ratings are conducted, or for real-time scores on companies, cities, or other entities. Some analytics firms (like MSCI) offer convincing pitches for their frameworks and analysis, but tend to be very expensive. Some organizations are more narrowly focused on one of the three ESG pillars (most often environmental factors.)
Here is a quick roundup of free, reputable resources for self-directed investors who are seeking to integrate ESG scores into their portfolio decisions.
- CPD – focused on a detailed set of climate change and environmental factors. These ratings are
- S&P 500 ESG Index – this resource won’t provide asset-by-asset ESG scoring or performance, but does provide scoring methodologies and names the top constituents of the S&P 500 that meet ESG criteria.
Generally companies that toute their ESG rankings and research tools will charge you for access (sometimes a lot.) Unless you are an ultra-high-net-worth investor or an investment advisor with substantial assets under management, this cost may be prohibitive. However, you can usually negotiate free trials periodically to gain insights, and often you can find timely information regarding the ESG profile of a particular company whose stock you are considering.
Analysis and research providers will probably cobble together SEC reports, social media activity, input from workplace research hubs like Glassdoor, etc. Organizations and research firms usually devise a proprietary weighting and scoring system based on numerous factors. Again, there is no accepted authority on ESG standards, and there is some room for subjectivity. Consider creating your own framework that borrows from what other organizations have delineated, and align it closely with your own values. I plan to write more on this topic in the future.