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Greetings from The Curious Cat!
We are back with an exciting edition for you. As companies gear up to publish their ‘integrated’ annual reports, a term that has gained visibility is a three letter word - ESG - featuring prominently in every annual report.
This word has made banks talk about energy consumption, IT companies speak on sustainable labour practices like upskilling the workforce, consumer goods speak on building communities of vendors and distributors, and promoter owned enterprises talk about transparency, integrity, and independence of decision making in their corporate governance disclosures.
What is this ‘ESG’ that these companies talk about? Another bubble marketed in an envelope of moral sanctimony to ensure a narrative of good around it? Or just corporate window dressing? Or a genuine approach towards building a better world?
Is it like the MSG in Chinese food which when added to your stock portfolio boosts returns? Should you consider investing in ESG stocks?
This week’s edition is dedicated to understanding the sustainable (ESG) investing philosophy and trying to find answers to the above questions.
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What is ESG?
Read in detail here
ESG is an acronym for Environment, Social and Governance. These (ESG) criteria are a set of standards for a company’s operations that investors use to screen potential investments. Environment criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.
They are an increasingly popular way of evaluating companies to invest and also help investors avoid companies that might pose a greater financial risk due to their practices.
This criteria has attracted eyeballs of various investors, consulting companies, reporting agencies and asset management companies who are offering various products.
In this issue of The Curious Cat, we explore -
Reasons for the rise of ESG
How Board members perceive ESG
How the elite fund managers use ESG
An alternative model to ESG - The Shared Value Approach
Key questions for ESG investors
Let us dive in
ESG - The Investor’s Revolution
Read the article here
ESG issues were of secondary concerns to investors but now there is a change in investors outlook as corporations are held accountable by shareholders for their ESG performance.
Sustainable Investing comprises of seven common strategies:
Negative/exclusionary screening - eliminating companies in industries or countries deemed objectionable
Norms based screening - eliminating companies that violate some set of norms
Positive/best-in-class screening - selecting companies with strong ESG performance
Sustainability themed investing - funds focused on a particular issue like clean water, etc.
ESG integration - including ESG factors in fundamental analysis of a stock
Active ownership - engaging deeply with portfolio companies
Impact investing - looking for companies with positive impact on ESG while still earning market returns
The heightened focus on ESG issues from investors is primarily due to six reasons -
The size of investment firms - A highly concentrated investment industry that has become too big to let the planet fail
Financial returns - Firms with better ESG record outperforming peers
Materiality - Companies that focus on material issues that matter to financial performance based on their industry outperformed their peers.
Growing demand - Many large asset owners like pension funds demanding sustainable investing strategies from asset managers.
An evolving view of fiduciary duty - Legal and regulatory guidelines mandating focus on ESG and an evolving belief that a failure to integrate ESG issues in performance is a failure of fiduciary duty.
Shareholder activism - ESG is an increased focus of these interventions and active managers with a long term investing time horizon want companies to address material ESG issues.
There are five actions that companies can take to prepare for a new era of sustainable investing -
Articulate your purpose - A statement of purpose is cornerstone of constructive engagement with all stakeholders
Improve engagement with shareholders - An integrated report is an effective way to demonstrate integrated thinking towards society and a long term value creation intent
Increase involvement by middle management - As middle managers commit resources to achieve the desired goals, involving them in identifying materiality issues through consultative conversations is a beneficial approach.
Invest in internal systems for ESG performance information - Developing internal standards, audits and standards to endorse ESG goals and track them.
Improve measurement and reporting - A good framework for thinking on standards are the United Nations Sustainable Development Goals for a sustainable future.
All companies can partner with investors and shareholders to reward them in creating long term value for the society as a whole.
How Boards View ESG
Read the article here
Driving sustainable business practices is a Board agenda but there is a substantial gap between aspirations and capacity of the Boards to deliver on these
There are five different archetypes of behavior with respect to board members’ individual attitudes towards ESG investing.
The Deniers - They see ESG as nothing more than a fad and a management buzzword.
The Hardheaded - They see ESG as a factor affecting their business but tend to reduce it to strategic reasoning.
The Superficial - They have a shallow understanding of ESG issues and are often scared of taking the lead.
The Complacent - They use past sustainability triumphs to shut down the conversation, many of them are early adopters of ESG practices who have not kept in touch with the recent changes.
The True Believers - For them, the long term economic viability of their organization is closely linked and dependent on social and environmental responsibility.
There are ways to manage these attitudes as the article describes and it concludes by stating that it is a matter of time before Boards find that bridging the gap between aspirations and actions is a requirement of fiduciary duty
So which of the archetypes do you fall into with respect to ESG?
How Money Managers Manage ESG Investing
Read the article here
Earlier ESG investing strategies focused on excluding bad actors, the concept has evolved into embracing the good actors directly funding promising ESG ventures, engaging with companies on ESG issues, and voting proxies to advance ESG goals. Each fund has a different approach with everyone having different perspectives on values and company ethics.
Some different types of ESG equity strategies are:
Passive Exclusionary - The fund takes the whole universe of US large cap and midcap stocks, then screens out businesses involved in fossil fuels, tobacco, alcohol, nuclear power, adult entertainment and gambling.It weights the filtered holdings on a market cap basis.
Focussed Active - The fund weeds out companies in the alcohol, tobacco, weapons, fossil fuels and focuses on exemplary management and high ethical standards. It focuses on companies with sustainable competitive advantages and products with strong growth potential.
Integrated Active - It chooses companies it thinks are standouts in their industries and have proven track records of capital allocation. It also emphasizes on corporate culture, employee engagement and adaptability.
In fixed income bonds, ESG practices have been lagging as most bondholders invest in government bond funds and do not have proxy votes like equity fundholders.
A fund’s ESG criteria needs to be always reviewed before choosing to pick that fund.
Why ESG had made fund managers rich?
Read the article here
The S&P 500 ESG index bet the normal S&P index by 0.6 per cent.
One reason for the extraordinary performance is that ESG portfolios have typically low exposure to fossil fuel assets for obvious environmental reasons which shielded ESG portfolios as oil prices collapsed in the year.
The other reason is better supply chain management and corporate governance. To get higher ESG ratings, companies need to audit their supply chains, employee practices and internal logistics, tweaking them wherever necessary.
A silver lining of COVID -19 is that it has supported the case for ESG investing
Notes on ESG Performance During The Pandemic
Read the article here
Joachim Klement writes that ESG investing is about managing risks that are not priced in the market and that there are massive risks that we might be aware of but that cannot be quantified properly but that can destroy performance in a heartbeat.
ESG funds have outperformed conventional funds probably due to luck. While ESG funds and sustainable investing cannot avoid every risk – after all, it is a risk management system and even in conventional risk management the goal is not total risk avoidance – it can help manage these unexpected risks. In other words, there will likely be more situations in the future when ESG funds will outperform conventional funds and then for the right reasons.
An Alternative to ESG - The Shared Value Approach
Read the article here
Michael Porter writes about an alternate approach called the “shared value” approach where he defines shared value as profit driven social impact. He writes that companies which successfully implement strategies to create shared value can deliver superior shareholder returns. Porter argues against the idea that companies which score higher on an aggregation of ESG metrics, with little consideration of their financial performance and its relation to the competitive strategy of a company, will deliver better shareholder returns. He articulates that the ESG criteria have been developed without regard to the causal link between a company’s social impact and its bottom line.
Porter writes that the larger goal of investing is to create a virtuous cycle by allocating capital to those companies that create the greatest societal returns — both in business as usual and in improving the welfare of customers, employees, suppliers, and communities. This virtuous circle drives present returns as well as future growth and opportunity.
Shared value can affect strategy at three mutually reinforcing levels:
Creating new products that address emerging social needs or open currently unserved customer segments
Enhancing productivity in the value chain, whether by finding new efficiencies or increasing the productivity of employees and suppliers
Investing to improve the business environment or industry cluster in the regions where the company operates.
Porter explains with examples for each level and concludes that shared-value companies make a different set of choices than their competitors, building a distinctive social impact into their business models. As a result, they deliver different returns to their shareholders.
It remains a new frontier for investors and must be combined with the conventional financial tools of security analysis.
Now that we know of an alternate option towards ESG investing, let us also look at few questions that an ESG investor must ask themselves
Ten Key Questions for ESG Investors
Read the article here
ESG investing is the dominant narrative in the asset management industry. Some important questions around ESG investment philosophy are:
Are you willing to sacrifice investment returns? - Investors need to consider whether they would be okay if their investment strategy underperformed a broad market benchmark for a sustained period.
Do any ESG elements constitute a risk premium? - Within the governance component that are intertwined with the quality factor can be considered a risk premium.
Should ESG assessments be absolute or relative? - The absolute option offers a level of ‘purity’ to the ESG philosophy but brings with it a cost on terms of a lack of diversification.
Should you worry about where a company is now, or where is it going? - If a key aim of ESG investing is to bring about a broader shift in corporate behavior, then giving some reward to positive change seems prudent.
Should you divest or engage? - It is crucial that you are able to justify and evidence your ability to influence a company.
Is active or passive the best approach? - It depends on your objectives and requirements but the broader question is whether a rules based decision making is sufficient or do you need additional qualitative judgment for an ESG oriented strategy?
Are the multiple ratings services a problem? - The absence of a standard ESG rating system could mean your portfolio having positive or negative ESG characteristics depending on the rating system you use.
Is ESG investing a bubble? - A nebulous concept and high subjectivity in evaluation means a widespread bubble is unlikely and difficult to define.
How do you balance principles and diversification? - You need to be aware of the trade-offs and their investment implications of each decision.
What matters and how much does it matter? - You need to be aware of the implicit assumptions and judgments you make in evaluating firms.
Mental Model For The Week - Halo Effect
Halo effect is a cognitive bias where we attribute the expertise of a person, popularity or positive impression of a brand in one area and influence our opinion in other areas. It occurs when a specific, positive characteristic determines the way a person is viewed by others on other, unrelated traits. In the case of beauty, it’s been shown that we automatically assign favorable yet unrelated traits such as talent, kindness, honesty, and intelligence, with those we find physically attractive. Other factors like similarity, familiarity along with appearance can also result in a halo effect.
Companies try to create the halo effect to establish themselves as leaders in their industries, establish brand loyalty and enhance customer engagement.
A good way to shield yourself from this effect is by asking yourself how much of what you feel is due to liking versus the actual facts of the situation. An inclination towards the former indicates the influence of the effect.
Do you think you can be susceptible to the Halo effect when choosing your ESG stocks?
Research Paper(s) For The Week
We reviewed two academic research papers that presented two different views on ESG investing as a practice -
This paper published in 2012 provides compelling evidence and builds a strong case for sustainable investing for superior financial returns.
You can read the entire paper here.
Previous empirical research suggested a positive relationship between ESG rating levels and returns. This paper published in 2015 does not show a significant difference in returns to the portfolios featuring companies with high and low ESG rating levels. The results suggest that investors should no longer expect abnormal returns by trading a difference portfolio of high and low rated firms with regard to ESG aspects.
You can read the entire paper here.
Afterthought
The only thing necessary for the triumph of evil is for good men to do nothing
-Edmund Burke
If reading today's edition has helped you get a better perspective on ESG, then the objective of this edition is complete. We believe that the answer to the question on whether one must consider investing in ESG funds is subjective and you need to find out the answer for yourself considering your risk appetite, current portfolio allocation and your personal values & goals in looking at potential investments.
We hope that this has helped you in giving a balanced view on sustainable investing.
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Take care, stay safe and have a nice weekend. We shall see you next Saturday.