ESG: Pleased to meet you, hope you guess my name

These days it feels like you can’t pick up a financial newspaper without reading an article or an advert    mentioning ESG, SRI or Sustainability. But what is it, and what does it mean for a value investor?

Well, here’s a beginner’s guide to what is rapidly becoming the new standard.

ESG (Environmental, Social and Governance) is an umbrella term for investments that seek both positive returns AND a long-term positive impact on society, the environment and the performance of a business. It is used by investors to evaluate companies and determine their future long-term financial performance.

There are several different types of sustainable investment. They include Socially Responsible Investing (SRI), Impact Investing (please refer to our blog https://www.cobasam.com/en/the-revolution-of-impact-investment/), and ESG.

Socially Responsible Investing (SRI) started in the 1970s as investors mostly used negative screening methods to exclude investment in guns, tobacco, gambling, adult entertainment and other vices.

Such a framework, contingent on one’s ethics and morality, or definition of “good” and “bad”, 

could narrow your universe of possibilities. This is an obstacle to building an optimal investment portfolio as it excludes, by nature, a stock with a very personal moral bias. Is alcohol “good” or “bad”, for example?

Impact investing is considered a more advanced and pure form of sustainable investing. It hinges upon generating a measurable environmental and social impact alongside financial returns. It promotes investment in a new category of companies that are self-sufficient, prosperous and run not only for their own benefit, but also for the benefit of society as a whole (https://www.cobasam.com/en/the-revolution-of-impact-investment/).

The goal of impact investing is to use money and investment capital to generate measurable positive social results.

ESG investing is the integration of environmental, social and governance factors into the fundamental investment process. Using an ESG framework, investors can select companies to invest in based on factors tied to the long-term durability of a company. In other words, companies that follow high quality Environmental, Social and Governance standards are more likely to outperform in the long-run (a familiar mantra for value investors!). These ESG criteria can also help investors to avoid companies that might carry greater financial risk due to their weak ESG approach.

To add a degree of complexity, these definitions are not set in stone and may overlap. Consequently, there are many ways to invest in a ‘responsible’ manner. Each asset manager ultimately decides their own approach.

Successful (value) long-term investors share some basic principles:

• Never accept short cuts such as following the crowd.
• Don’t be distracted or taken in by ‘market noise’.
• Always do your own analysis on a company, before investing your hard-earned money.
• Long-term success demands deep-dive research and
• …don’t be influenced by short-term volatility.

A successful ESG asset manager also typically follows the rules above.

First, the asset manager will identify a set of compelling investments, based on their traditional investment selection philosophy, after which they will add an additional lens of financial criteria that they might think relevant to measure long-term predicable success or a possible array of risks. For value investors, this means picking stocks that are trading more cheaply than their intrinsic value. Subsequently, the value asset manager will apply an ESG filter. These filters are not a list of exhaustive screeners, but a selection of extra financial lenses to be used at the discretion of the asset owner. The impact and returns don’t need to be mutually exclusive since this ESG filter is only applied after a pre-stock picking based on a value-based approach. Those add-ons are a subdivision of non-financial performance indicators which include sustainable, ethical and corporate governance issues.

There is a common misperception that ESG integration will adversely affect financial performance. Numerous studies show the opposite in the long run, (https://www.tandfonline.com/doi/full/10.1080/20430795.2015.1118917)

ESG filters influence the construction of investment portfolios and can be used to assess the risk of the strategies incorporated into both investment decisions and risk management processes. 

Unsurprisingly, a vast majority of value asset managers have been actively involved in the companies in which they invest. Their long-term vision forced them to look at companies as if they were owners “forever”, to determine the moat of the business, and how to preserve their asset over the long term. This was mainly done via a corporate governance examination, and an assessment of the quality of a business, such as an analysis of social and environmental concerns. Long before ‘ESG screening’ became fashionable, value investors would carry out such an analysis as a matter of course.

While there are a wide range of ESG investment approaches that can take various forms, they all provide value managers with an opportunity to broaden and deepen their long-term commitment towards the management teams of the companies in which they invest and to improve their knowledge of their investments.