The art of investing requires a broader skill set—more perceptive thinking, insight, intuition and even an awareness of psychology—things that Howard Marks, Co-Chairman of Oaktree Capital Management, refers to as “second-level thinking” in one of my favorite books on investing: The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor (46).
The purpose of this article is to stretch your second-level thinking skills. Specifically, we will explore how investors (private, institutional and asset managers) can make sustainable and responsible investment choices by carefully analyzing environmental, social and governance (ESG) issues within the investment decision-making process. In short, it’s about reducing risk and generating return while investing in firms that add value to society—producing profit with a sustainable purpose.
ESG for Alpha
On Feb. 19 CFA Society Chicago explored these issues at a conference entitled “ESG for Alpha” where top investment managers and institutional investors gathered to discuss the past, present and future of Sustainable, Responsible and Impact investing (SRI). As the conference title implies, a key question is whether ESG issues can be used to produce superior risk-adjusted returns (or alpha) that beat the market —but more on that later.
John Mirante, CFA, CPA, and Senior Relationship Manager, BMO Global Asset Management welcomed the audience and explained that there’s currently a plethora of terminology used to describe investments that take ESG issues into account including: sustainable investing, ethical investing, socially responsible investing, responsible investing, green investing and impact investing. While there are some distinctions between these terms they all generally emphasize two key factors (1) a long-term investment horizon and (2) ESG issues.
Let’s start with the basics. Although there’s no “single list” of ESG issues, and not every issue fits neatly into just one category, we do have a general understanding of the major issues:
Environmental Issues: Carbon emissions, greenhouse gas emissions, climate change impact on company (risk exposures and opportunities), ecosystem change, facilities citing environmental risks, hazardous waste disposal and cleanup, pollution, renewable energy, resource depletion and toxic chemical use and disposal.
Source: CFA Institute, “Environmental, Social and Governance Factors at Listed Companies: A Manual for Investors” (May 2008).
Social Issues: Customer satisfaction, data protection and privacy, diversity and equal opportunities, employee attraction and retention, government and community relations, human capital management (including training and education), human rights, indigenous rights, labor standards (including freedom of association and collective bargaining, child labor, forced labor, occupational health and safety, living wage), product misspelling, product safety and liability, supply chain management.
Source: PRI, Principles for Responsible Investment (in partnership with UN Environment Programme Finance Initiative and UN Global Compact),”Responsible Investment in Private Equity: A Guide for Limited Partners,” 2nd ed. (June 2011): 25.
Governance Issues: Separation of CEO and Chairman roles, appointment of independent lead director, independent compensation and nomination committees, audit committee independence, ration of non-audit to audit fees paid to the assigned auditor, CEO compensation as a % of cash flow, fair value of share-based compensation expense as a % of cash flow, ownership blocks greater than 5%, staggered board, poison pill, unequal voting rights.
Source: Goldman Sachs Global Investment Research, “GS SUSTAIN: Challenges in ESG Disclosure and Consistency” (October 2009):6.
Why do ESG issues matter?
Bruno Bertocci, Managing Director and Global Equity Portfolio Manager, at UBS Global Asset Management (Americas) Inc.really put it all into perspective when he described ESG issues as “material non-financial factors.” In other words, ESG issues are rarely quantified in the cold, hard financial data of the annual 10-K or quarterly 10-Q. Yet, they can be material and significantly impact future cash flows and firm valuations. They are hard to quantify but can be incredibly important to the investment decision-making process. As one famous physicist once said:
“Not everything that counts can be counted and not everything that can be counted counts.” Albert Einstein
You might recognize Mr. Bertocci’s approach as solid fundamental analysis. It’s the part of investment analysis that’s more art than science. Bertocci explains, “I’ve really always thought about it this way.” He explains that he went to work for T. Rowe Price when he got out of business school. But Bertocci notes, “I didn’t know how to pick a stock with my chemistry background.” Then, he reviewed T. Rowe Price’s notebooks on DuPont in the company library on their new product—nylon. Price had gone to the dime-store and observed that, “The ladies loved nylon. It was cheaper and lasted longer.”
Mr. Price’s observation was not a financial factor but Bertocci reminds us that it must be material and it must impact the business product—otherwise you are just wasting your time.
Bertocci also explains that material non-financial factors are data that can confirm or deny your expectations in the tails of the distribution. In other words, the stock might appear cheap on a discounted cash flow basis but ESG factors may reveal it’s a deteriorating business model. He believes ESG factors are an extension of mosaic theory and should be ranked in conjunction with the financial data. By doing so, you improve your information coefficient.
Again, I’m reminded of Howard Marks who says,
“Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both” (78).
Today, Bertocci expects his day-to-day analysts to gain access to ESG information because he believes it’s predictive of future returns. He wants a technology analyst to compare Intel to Taiwan Semiconductor and then to have a conversation about the energy efficiency of one versus the other. Bertocci goes on to explain, “In my experience, the really big money is made with a long-term perspective that the market does not recognize.”
Creating Shared Value
Time for a short commercial break. By now, you probably agree that evaluating material non-financial ESG factors can add value to the investment process. But which firms are good at creating value in a “sustainable” fashion? And what does that really mean anyway?
In this regard, Bertocci recommends reading “Creating Shared Value” by Michael E. Porter and Mark R. Kramer, Harvard Business Review, January 2011 issue. In short, Porter and Kramer argue that creating societal value is a powerful way to create economic value for a business. In fact, there are vast unmet needs in the world and businesses that meet societal needs will significantly differentiate themselves and enhance their competitive position.
Creating value for the business and the community does not have to be a zero sum game. It doesn’t have to be an either or dilemma of profit that comes at the expense of the community. Think about expanding the pie rather than slicing it up and you have a positive sum game. It’s about doing good and doing well at the same time.
Principles for Responsible Investment (PRI)
Sustainable investing is moving much faster on the other side of the pond. Vicki Bakshi, Head of Governance and Sustainable Investment, F&C Investments explained that the United Nations-supported Principals for Responsible Investment (PRI) initiative is ubiquitous! She reports that there has been more forward thinking on ESG issues in Europe than in the US for a long time. Bertocci agrees and says, “you can’t win a public fund mandate in Europe if you don’t know the ESG issues.”
Today, there are 1,325 signatories to the PRI initiative representing asset owners, investment managers and service providers with $45 trillion (USD) in assets under management. These signatories voluntarily commit to recognizing the materiality of ESG issues by adhering to the following six principles:
- We will incorporate ESG issues into investment analysis and decision making.
- We will be active owners and incorporate ESG issues into our ownership policies and practices.
- We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- We will promote acceptance and implementation of the Principles within the investment industry.
- We will work together to enhance our effectiveness in implementing the Principles.
- We will each report on our activities and progress towards implementing the Principles.
Importantly, Bakshi describes F&C’s process of digging deeper in their requests for proposals (RFPs) to uncover the actual extent to which ESG factors are incorporated into asset manager’s investment decision-making process. Bakshi says, “we want to differentiate [ourselves] from tick boxes with six pages of questions on ESG factors. We ask (1) what is your process? and (2) give me examples of when your valuations changed as a result of ESG factors.” Today, Bakshi sees more engagement by institutional asset owners voluntarily reporting on stewardship in their mainstream reporting. In addition, she points out that the Dutch are the most advanced in this area today and it’s also spreading to even larger funds.
Lucas Mansberger, CFA, CAIA, Consultant with Pavilion Advisory Group Inc., facilitated a panel discussion with asset owners to discuss how they incorporate ESG issues into their investment process. The audience agreed with Mansberger as he emphasized that ESG questions on RFP’s are becoming increasing more detailed and difficult to answer.
Given the incredible economic and social importance of ESG issues, not to mention the growing scale of ESG investing ($45 trillion), it’s critical for asset owners and managers to be proficient in applying practical methods to address ESG issues within their investment decision-making process. The most common “ESG methodologies” to accomplish this are:
- Active Ownership
- Best in Class Selection
- ESG Integration
- Exclusionary Screening
- Impact Investing
- Thematic Investing
For most people, exclusionary screening is the first thing that comes to mind. Simply put, it’s avoiding certain companies based on ethical concerns or norms. Kristy Jenkinson, Managing Director Sustainable Investment Strategies,Wespath Investment Management, explained that Wespath excludes firms that earn significant revenues from gambling, alcohol, tobacco, pornography, weapons and the operation of prison facilities as part of their ethical exclusions. Wespath is a division of the General Board of Pension and Health Benefits of the United Methodist Church with approximately $21 billion under management.
Likewise, William Atwood, Executive Director for the Illinois State Board of Investment (ISBI), indicated that the State of Illinois has a number of statutorily mandated investment exclusions. These include a Sudan Divestment Policy for human rights violations and exclusions of oil-related and mineral extraction sectors in Iran due to current US sanctions against Iran for seeking to acquire weapons of mass destruction and for supporting international terrorism. The ISBI is responsible for managing the over $ 15.1 billion in assets for Illinois’ General Assembly Retirement System, Judges’ Retirement System and the State Employees Retirement System.
Atwood also explained that ISBI’s investment managers proactively look for buildings that meet LEED green building standards because they add value to the portfolio of properties and have an impact on the bottom line. In addition, ISBI looks for minority and female-owned brokerage firms and investment managers as well. In this regard, Atwood notes that the inclusion of “non-Wall Street” managers provides ISBI with additional diversification of investment and operational risk.
In addition, both Jenkinson and Atwood are engaged in active ownership in which they aggressively vote on proxy issues and engage with management on key issues. Atwood’s been involved in “say on pay” issues to address executive compensation and Jenkinson mentioned engaging on climate change and human rights issues. Bertocci also pointed out that the very best analysts think about management quality, governance and how management incentives benefit shareholders and drive behavior.
ESG Integration refers to making explicit inclusion of ESG risks and opportunities alongside traditional financial analysis but does not necessarily require a peer group comparison like best in class selection. And best in class selection prefers companies with better ESG performance relative to their sector peers.
Wespath was a primary signatory to the United Nations Principles for Responsible Investment (PRI) and asks all of their money managers to adopt it—and about 80% of them have. Wespath then benchmarks its managers against their peers to assess their ESG integration. This assessment includes comprehensive questions on who reviews and approves the ESG policy, how often it’s updated and how it’s incorporated into compensation, training and performance.
Impact investing attempts to generate and measure social and environmental benefits along with a financial return. Finally, thematic investing is based on emerging trends such as social, demographic and industrial trends. But how can a money manager or an institutional investor effectively measure “sustainability?” The good news is that new standards for sustainability reporting are improving dramatically.
Sustainable Accounting Standard Board (SASB)
Jenkinson points out that many corporate sustainability reports are “murky at best and terrible at worst.” Often, corporate sustainability reports simply highlight only corporate charitable contributions and the annual volunteer day in the community. Fortunately, Bertocci and Jenkinson point out the value of SASB and its work to help organizations identify material, decision-useful information for investors.
The Sustainable Accounting Standards Board (SASB) is a 501(c)3 non-profit that helps corporations disclose sustainability information that’s useful to investors. Importantly, the SASB Materiality Map can help companies and investors identify issues that are most likely to be material on an industry-by-industry basis (e.g. health care, non-renewable resources, financials, technology and communications, transportation and services). Then, for example, within the non-renewable resources industry the map identifies the sector (e.g. oil and gas midstream) and then identifies certain environmental issues (GHG emissions, air quality, biodiversity impacts) and, in this case, governance issues (accident safety and management, competitive behavior) that are most likely to be material for more than 50% of the industries in the sector.
Ultimately, Bertocci would like to imagine a world where there is a willingness of the company to adhere to SASB standards and willingly move sustainability data into the body of mock 10Ks. Then, Bertocci says the information must be provided to the firm’s external auditors so that reasonable assurance can be provided on the materiality of the reporting.
Jenkinson expressed less interest in the form of the reporting (e.g. integrated as one report or as a separate ESG report) but emphasized that she wants to know if the firm is really integrating ESG issues in the actual strategy and risk management activities of the firm.
The Elephant in the Room – Alpha
Linda-Eling Lee, Ph.D., Global Head of Research for MSCI’s ESG Research Group, who moderated the asset manager panel discussion, addressed the elephant in the room by asking, “Does ESG hurt your returns? Yes or No?”
Let’s face it, professional investors and academics know its difficult to generate alpha and consistently outperform the market due to skill rather than luck. TheEfficient Market Hypothesis (EMH), in all of its forms, suggests that all available information is already incorporated into the price of a security and suggests that it’s essentially impossible to beat the market. Bertocci points out that even large asset managers still question active management. Even worse, there can be a general perception that ESG hinders returns.
Yet, Sir John Templeton, CFA, was an extremely successful investor who did not invest in businesses engaged in tobacco, alcohol, gambling and tobacco based on moral grounds (exclusionary screening). In addition, CalPERS (the California Public Employee Retirement System) has effectively engaged with underperforming companies and generated excess returns relative to their benchmark (CalPERS Towards Sustainable Investments & Operations – 2014 Report (15).
The short answer is that academic research studies on investments that take ESG factors into account show no consistent outperformance or underperformance (CFA Institute – ESG-100 Question #69). In other words, the studies have found no systematic bias either way. But clearly, the academic difficulty of attributing abnormal excess return (alpha) specifically to “E, S and G” factors alone won’t discourage successful investors from identifying incredibly valuable ESG issues (material non-financial factors) that can reduce investment risk, avoid losses and exploit opportunities for higher returns. Here are some examples:
Adam Strauss, CFA, Co-Chief Executive Officer of Pekin Singer Strauss Asset Management and Co-Portfolio Manager of theAppleseed Fund (APPLX, APPIX) says, “There are two important rules to remember about investing: Rule #1: Don’t lose money and Rule #2: Don’t forget rule #1.”
Strauss offers two examples of successful ESG investing. First, he explained that Pekin Singer Strauss looked at investing in BP in 2009; however, their analysis concluded that the company had a safety culture problem based on the March 23, 2005 BP Texas City Refinery explosion, the 200,000 gallon Prudhoe Bay oil field spill in March of 2006 and several other incidents. Therefore, Strauss avoided the 52% drop in BP’s stock price (from $60 to about $29) 50 days after the Deepwater Horizon accident on April 20, 2010. Strauss noted that the safety culture issue was not on the balance sheet but it was a material issue.
Secondly, Strass cited John B. Sanfilippo Inc. (JBSS) as having positive ESG factors prior to Pekin Singer Strauss’ investment five years ago. According to Strauss, JBSS has a responsible management team that’s well aligned with shareholders and stakeholders and an environmentally sustainable food product that’s good for human health that offers a high-quality source of vegetarian protein. Their nut products even take less water and land per pound of protein to produce than other sources of protein.
Vicki Bakhsi added that F&C Investments excluded Brazilian oil giant Petrobras for investments in 2012 due to their poor protection of minority shareholder voting rights. And, as we all know, corporate governance issues have continued to plague Petrobras as they are currently involved in a corruption scandal. F&C actively engaged with Hon Hai (Foxxcon), the largest manufacture of Apple products, by visiting their factories and found that their labor polices were generally good but monitoring and implementation was weak. One year after F&C engaged Hon Hai management on these issues their processes improved. That’s effective engagement on an important governance issue.
Finally, Bertocci reminds us that the incremental benefits of the “E” and the “S” (in ESG) really depend on the business. For example, at Adobe energy costs are not material but at a steel company they obviously would be significant. He says, “we must not paint the analytical process as the same for everyone.”
In the investment world, institutions like universities, hospitals, foundations and public and private pension plans have a fiduciary duty to the beneficiaries of their plans.
“A fiduciary duty is a legal duty to act solely in another party’s interests. Parties owing this duty are called fiduciaries. The individuals to whom they owe a duty are called principals. Fiduciaries may not profit from their relationship with their principals unless they have the principals’ express informed consent. They also have a duty to avoid any conflicts of interest between themselves and their principals and the fiduciaries’ other clients. A fiduciary duty is the strictest duty of care recognized by the US legal system.” Legal Information Institute, “Fiduciary Duty: Definition,” Cornell University Law School.
Atwood explained that ISBI has a fiduciary duty to maximize the risk-adjusted rate of return their pension plans. Ten years ago, Atwood noted that many asset managers felt it would be inappropriate to incorporate ESG issues into the investment-decision making process out of fear of violating fiduciary duty. Those who take this stand typically argue that it adversely affects financial performance. However, this view is changing today.
Notably, the international law firm Freshfields Brockhaus Derringer produced a report entitled “A Legal Framework for the Integration of Environmental Social and Governance Issues into Institutional Investment” in 2005 which covered nine jurisdictions (Australia, Canada, France, Germany, Italy, Japan, Spain, the United Kingdom, and the United States) and concluded that:
“…integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.” (13)
Constituent Demands – Fossil Fuels
At the same time, institutions can face demands from their constituents (and organizations like 350.org) to divest from areas like fossil fuels out of concerns for the environment and global warming. In this regard, Australian Natural University (ANU), Stanford, University of Dayton, University of Glasgow (U.K.), Pritzer College and San Francisco State have opted to sell either their coal or fossil fuel investments. (See “Fossil Fuels Stir Debate at Endowments” by Dan Fitzpatrick, The Wall Street Journal 9 Sept. 2014) Furthermore, at the U.N. Climate Summit in September of 2014, more than 800 institutions and individual investors, with more than $50 billion in assets, vowed to divest from fossil fuels. On the other hand, Harvard, Yale, Cornell and Brown have elected not to divest.
The arguments for divestment are often for either moral or financial reasons. From a financial standpoint, some wonder if we are creating a “carbon bubble” from excess fossil fuel reserves on balance sheets that may never be burned and later resulting in stranded assets.
On the other hand, as reported by the Associated Press, Harvard’s Robert Stavins argues that divestment is largely a symbolic act—without much direct impact on CO2 emissions—that can distract from more meaningful activities. (See “Should Endowments Divest Their Holdings in Fossil Fuels?” The Wall Street Journal 23 Nov. 2014.)
In my opinion, the significance and materiality of ESG issues cannot be ignored in the investment decision-making process. They must be integrated into the process. We may debate the risks of global warming but few would argue that the air quality in Beijing or Shanghai is any good—so one way or another things will have to change. (See Chai Jing’s Under the Dome – Investigating China’s Smog) As a result, failure to understand how sustainability issues impact your investment portfolio can lead to significant risks and missed opportunities.
As Howard Marks says,
“Inefficiencies—mispricings, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes” (342).
Additional ESG Resources
ESG-100 – CFA Institute, CFA Institute – ESG Resources, Environmental Markets: A New Asset Class
Dow Jones Sustainability Indicies, FTSE4Good Index Series, MSCI ESG Indexes,MSCI ESG Research Products
UNEP Finance Initiative, Carbon Disclosure Project – Driving Sustainable Economies, ISO 14000 Environmental Management Certification, GRI – Global Reporting Initiative