Why ESG research matters for mainstream investors by Robert McConnaughey, Director of Global Research, Columbia Threadneedle Investments

  • While the risks and opportunities ESG research strives to assess have always been around, we believe their significance to investment outcomes is only growing.
  • One potential source of opportunity for locating market inefficiency is by taking a hard look at underappreciated longer term risks and opportunities.
  • Building a research process supported from multiple perspectives that include ESG work is, in our view, the only way to properly identify those sorts of risks and opportunities.

There has been tremendous growth in demand for investment strategies that take issues into account regarding the environment, social impact and overall responsible governance (ESG). While the early drivers of growth were European institutions, demand is spreading rapidly to U.S. entities as well as global high-net-worth and retail individual investors. In fact, one out of every six dollars under professional management in the U.S. now is invested with sustainability in mind, up from one out of every nine dollars two years ago. Not coincidentally, 75% of S&P 500 Index companies now produce a sustainability report, up from 19% in 2011. Despite growing interest in responsible investing, significant skepticism exists regarding opportunities for enhanced returns or more effective fiduciary decision-making through a focus on ESG research. There are those who feel that focusing on values is a distraction from a pure focus on the bottom line. I disagree. Enterprises that show respect for their communities while balancing responsibilities to their stakeholders are more likely to accrue positive brand value and customer loyalty while avoiding risks of societal rejection of or restraint on their actions. I am a firm believer that thoughtful and properly applied ESG research can be a powerful tool in a positively differentiated assessment of the long-term risks and opportunities in the markets. However, I would emphasize the “thoughtful and properly applied” part of that statement. An ESG-driven focus without broader market perspective or integration into a well-disciplined investment process does strike me as possibly unintentionally damaging to investor opportunities, and thus ultimately likely to be of little impact to society.

Many investors will quickly acknowledge that the G (governance) in ESG is an important area to focus on. However, those same observers often seem to feel that the E and S (environmental and social) are merely the domain of well-intentioned, but naïve “tree-huggers.” I believe strongly that that view is incomplete and incorrect. There is clear evidence that environmental and social issues are of significant longer term importance to investor outcomes. These issues are best evaluated through integrating an ESG research effort into the research toolkit. Practices that run afoul of the values of the communities in which they occur create risk of regulatory, customer or employee backlash. This backlash can cause major disruption in the sustainability of an enterprise’s positive trajectory. Investing in demonstrable respect for all stakeholders might weigh on near-term profitability, but so might appropriate investment in research and development to generate innovation and organic revenue growth. Avoiding either would be penny-wise and pound-foolish, and, thus, ultimately bad for enterprise value. Sustainability may seem to be a loaded word, but in this case I mean it to apply to the longer term sustainability of revenues, profits and cash flows — the heart of an investor’s interests.

A few examples of environmental and social issues that are top of mind in today’s markets and substantive to complete analysis:

  • Plotting the trajectory of decline for coal’s share of U.S. and, to a lesser extent, global energy use. Growing concerns about coal’s environmental impacts have caused tighter regulatory policy across many of the world’s largest economies. Not only has this had a major impact on coal producers themselves but on many peripheral businesses such as railroads.
  • Copper mining is a water-intensive process and, in the midst of a serious drought, the Chilean government is acting on concerns surrounding mine water use from the broader community. The only solution for the massive mines will be desalination plants that will significantly raise the cost of mining. Chile is not alone in these sorts of concerns, but is particularly relevant because it is a low-cost producer and the source of more than one-third of the world’s copper production.
  • Data security and privacy issues are concerns for many businesses (and opportunities for some). A retailer without a strong online presence may struggle in today’s world, and one that cannot protect the data of its customers will suffer tremendously.
  • As the world’s wealth is increasingly driven by intellectual property, human resources practices to attract, retain and incent highly-skilled employees are an increasingly important focus. For example, ten years ago, there would have been little investor focus on the matter, but today, an enterprise that limited benefits to same-sex partners would likely see significant customer, employee and vendor impacts from that decision.

These levels of enterprise sustainability may be difficult to assess accurately without bringing an ESG perspective to bear in conjunction with more traditional fundamental and quantitative investment techniques. Either perspective alone might present an incomplete picture. Looking at the extreme tails of virtually any systematic valuation discipline, it becomes clear that one major reason that the securities are priced cheap to the rest of their universe is potential risk overhangs that may not be easily accounted for. The classic example of this phenomenon is the tobacco industry, which has usually traded at a discount to other consumer staples alternatives due to the risk of regulatory overhang. Knowing which of those cheap investments are not actually discounted enough for the existential risks to their businesses is crucial to avoid value traps, and ESG research may be a valuable tool in that effort. Also, ESG research should not be viewed as a binary tool separating good investments from bad. There are many shades of gray in assessing the levels of risk associated with certain behaviors and practices, and ESG research can help scale the probability and severity of those risks. ESG research, as part of a broader fundamental and quantitative research effort, seems more likely to not only identify that level of risk, but also how much those risks are discounted into the price of the potential investment, and how they fit into a broader picture regarding an enterprise’s competitive positioning and place in an investment portfolio. This distinction is important. If one wants ESG-influenced products to grow in impact on society, one should also want to deliver attractive and competitive financial returns for those products. Making investment decisions without an ESG perspective might give one an incomplete picture; conversely, building investment strategies with only an ESG perspective seems quite incomplete as well.

While the sorts of risks and opportunities ESG research strives to assess have always been around, we believe that their significance to investment outcomes is only growing. This is not only as a result of larger pools of capital focused on the incorporation of ESG disciplines, but also a function of changes in our world. Increased globalization has elevated the interconnection and transmission routes of risk and opportunity across the world. This is not just a function of growth in global trade, but also cross-border connections such as the influence of social media. Also, the nature of stores of value in our world has evolved. An increasing level of the world’s wealth is not measured in tangible book values but in levels of intellectual capital and brand value. The valuation of such assets can be more greatly influenced by changes in market perception regarding the longer term life-cycle and sustainability of the assets in question. Finally, it is clear that investor holding periods have steadily shrunk over time. As larger and larger sums are invested on a shorter and shorter term basis, one potential source of opportunity for locating market inefficiency is by taking a hard look at underappreciated longer term risks and opportunities. While the market may not be focused on them today, those issues, as they are revealed, will be discounted into current values. The long term often comes to the present far sooner than the market expects. In our view, building a research process supported from multiple perspectives that include prominently featured, robust ESG work is the only way to properly identify those sorts of risks and opportunities.

Why ESG Research Matters For Mainstream Investors