Data privacy breaches. Emission control scandals. Fake bank accounts created by employees. All are examples of businesses making poor environmental, social and governance (ESG) decisions that bit them in the rear.
If you haven’t heard of ESG investing, you will. Increasingly popular among institutional investors like pension funds, it’s going mainstream. Alongside traditional analysis of companies’ financial statements and corporate strategy, ESG emphasizes wide ranging factors that often blow back on a stock’s price.
ESG isn’t about punishing bad actors or pushing for social change. Markets are way too efficient for boycotts or divestment to accomplish anything at all. Rather, it’s about assessing nonfinancial factors potentially dinging returns.
For the “E,” that means considering how their environmental exposure affects future profitability. Are they energy- and resource-efficient enough to thrive in an increasingly green-focused world? Or are they big polluters and vulnerable to potential future climate rules? Are energy firms focused solely on fossil fuels or are they also diversifying research into renewables and emission reduction?
Same with the “S.” Does the firm contribute to or detract from society? Markets regularly punish detractors. What is the company’s relationship with its employees? Is there a revolving door among lower-level workers or management? Top places to work attract top talent. Happy, well-paid workers are more productive and loyal, improving long-term performance. If a worker exodus explodes, so will the stock. Similarly, businesses with good relationships in the communities where they operate are likely less vulnerable to new local taxes, regulations and lawsuits. Good community standing also makes it easier to get governmental permits when it’s expansion time.
The “G” directly relates to core business functioning. Governance refers to the systems, structures and policies governing a corporation – all of which affect profitability and stock market valuations, and should. How competent is the board? How good are they at protecting and enhancing shareholder value? Does management act with integrity? Do they offer optimal incentives? Manage reputational risk? Have great relationships with regulators? A culture of strong compliance?
While the ESG label is new-ish, incorporating ESG-type analysis in portfolio management isn’t. My first book, 1984’s No. 1 top-selling investment book “Super Stocks,” highlighted multiple factors now central to ESG investing. On labor and employee relations, I detailed why a great stock has a culture “that makes employees feel that they are treated with dignity … and exist in an atmosphere where constructive ideas from subordinates are encouraged and financially rewarded.” That’s all “S.”
I also stressed the importance of close attention to a company’s financial controls and the auditors standing behind them – basically, protecting it from becoming another Enron. That’s “G,” along with the importance of understanding who controls the firm and what good management/shareholder alignment looks like.
Is ESG right for you? It depends. Good ESG analysis encourages you or your adviser to evaluate potentially important factors more deeply. Some advisers routinely incorporate ESG without advertising it. Others push it hard as a selling point. But be wary of overly simplistic ESG strategies. For example, some will never own energy stocks, fretting over greenhouse gas emissions. Yet like all categories, energy stocks lead sometimes and lag at others. Blanket elimination can mean forfeiting future returns. This is supposed to be about analyzing aspects fully and carefully. You might want energy companies that are developing new technologies and practices to limit emissions while omitting those with significant future environmental liabilities.
Ultimately, ESG is about finding stocks best able to thrive in an ever-changing, increasingly socially conscious world. It’s like mosquito repellent. You don’t do it for the smell but for the protection.
This article provided by NewsEdge.