Can investing in equities according to the UN’s ESG principles (environment, social, governance) add value? Can such a strategy prove profitable according to the investment principles promulgated by Ben Graham or Abby Joseph Cohen?
The world’s largest asset managers seem to think so. An increasing percentage of assets under management are allocated using this socially responsible approach and individual investors have joined the trend.
ESG investing is difficult to define and measure because the underlying principles are extremely vague. They talk about environmental awareness, general inclusion and “best practices” in corporate affairs. But there are few clear definitions, uniform standards or reliable references. Many investors rely on third-party ranking providers, such as the FTSE-Russell Index. Sadly, the underlying scorecards are inconsistent and much of the wisdom of these rankings is disputed.
For some, ESG investing is a whole new style of investing. Rather than stake capital for economic gain, they redefine investment as stake capital for utility, including economic and psychic benefit. From this perspective, the very fact of siding with ESG principles immediately offers investors a value derived from virtuous action.
While such a utility ESG investment is a rational approach, there are two issues. First, empirical evidence shows that the implicit boycott of these investors – withholding capital from ESG deviants – is not sufficient to induce the desired behavioral changes of companies. An academic article concluded that instead of withholding investment, shareholders only succeed in effecting such changes by investing enough to take control of the target company, much like activist shareholders recently took seats in ExxonMobil advice.
The second problem with ESG investing is sociological. Research advocacy asserts that many ‘social’ impact investments aimed at helping targeted communities actually harm them. For example, some investments in affordable housing are condemned as “profiting from our pain” when investors fund projects with little input from concerned members of the community.
Is ESG worth it?
But the question remains: is investing in ESG companies a prudent investment strategy? Can it outperform (add “alpha” in the context of asset managers who exceed the benchmarks of their peers? Alpha is achieved when the investor correctly anticipates the costs / benefits that the market has underestimated at the time of investment. With ESG, this means discerning how companies will benefit from – or be harmed by – government policies or the development of innovative approaches on topics such as climate control, workforce diversity. or business administration.
This approach, however, reveals that there may be nothing new or special about ESG investing that has not been captured by generations of investment theorists, such as Phil Fisher, Peter Lynch or Warren Buffett. That is, the investment is inherently forward looking and an effective analyst assesses the big picture by projecting performance. ESG adds little to the toolbox, as smart investors have always benefited from the emphasis on sustainability, constituent protection, and management integrity.
Supporters might say that what’s different about ESG investing is that it is both a smart investment and good for the company. While some contemporary economists suggest that supporters can’t have it both ways – that you can’t both help society and your own wallet – it’s the age-old claim to do good by doing good.
In fact, the global market may shift from ESG indifference to ESG enthusiasm. The result: cash flow to ESG companies pushes up their stock prices, which generates short-term gains. (While these higher prices mean lower expected long-term returns, the process can take many years.)
The most cynical take on the hype of ESG investing is that it doesn’t generate positive social value or alpha. Critics in this vein allege that ESG has been primarily marketing – and a dangerously deceptive campaign at that. ESG has certainly become a promotional tool for a diverse cohort of professionals, including information companies, law firms and consulting firms, and it requires a wide range of skills, encompassing climate scientists, sociologists and business administration and legal experts.
But the traditional investor has always had to be a generalist, and the fundamentals of ESG correlate with some venerable aspirations, such as long-term sustainability, constituents besides shareholders, and good management. With this in mind, ESG is old wine in new bottles – a new name for a venerable practice.
For individual investors and asset managers, my advice is to integrate ESG concepts into its overall investment process, just as others have incorporated perspectives such as competitive advantage or corporate culture into valuation of a company. Well managed by shareholders focused on the long term (quality shareholders), there is an excellent chance that the investor can do well by doing good.
Lawrence A. Cunningham is a professor at George Washington University, founder of the Quality Shareholders Group and editor, since 1997, of “The Essays of Warren Buffett: Lessons for Corporate America”. For updates on Cunningham’s research on quality shareholders, sign up here.
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