Impact Investing

Investors around the globe are more informed, interested and educated on environmental, social and governance issues (ESG).

In this article we will discuss several social and governance issues that continue to make headlines as well as the impact of incorporating ESG criteria into portfolio construction considerations.

“All the Money in The World,” a December 2017 movie release about the kidnapping of 16-year-old John Paul Getty III became embroiled in controversy when reports surfaced that Mark Wahlberg earned 1500 times more than co-star and acclaimed actress Michelle Williams for recuts. Unfortunately, gender pay discrepancies are far from the only social issue gripping Hollywood. Sadly, publicly-traded corporations also find themselves in the headlines for similar and other unflattering issues.

S&P 500 CEOs, no strangers to the real-life game of “All the Money in the World,” had some excess compensation issues of their own making headlines in 2018. The Wall Street Journal reported the median CEO compensation rose to a record $11.6 million in 2017 while the average employee annual compensation remains well below pre-2008 recession levels. We also learned Tesla CEO, Elon Musk, was granted a suspected record multi-billion 10-year stock option package—though not guaranteed. And his company lost $2 billion in 2017. So much for rewarding profitability.

Not all CEOs were in celebration mode. Disgraced Casino Mogul Steve Wynn, who recently resigned in the wake of multiple sexual misconduct claims, will not be receiving a penny of his $330 million severance package. That Board of Directors has an abundance of unanswered questions to address irrespective of the rescinded severance package. Publicly-traded companies need to remember how we vote as shareholders and which companies we decide to add or subtract from our portfolio reflects more than just their quarterly earnings releases. {Editors’ note: If you are a Netflix subscriber and interested in stories of brazen greed, abusive power and corruption, we recommend checking out “Dirty Money.” Episode one highlights corporate governance gone awry at Volkswagen (with the unraveling of lies and deceit causing the company’s stock price to decline from 250 Euros per share to under 100)}.

Facebook has recently become an interesting study in social and governance matters following confirmation that personal data of users had been misappropriated. Legendary investor Warren Buffet also finds himself entangled, albeit from afar, in a different type of corporate scandal as the stench from one of his largest holdings, Wells Fargo, gets worse by the day. Investing requires trust, and trust can easily be fractured when proper controls and procedures are lacking. How companies respond from being reassigned from a “liked” to “unliked” category can have long-term implications for their future success.

As a fiduciary for our clients, we have opportunities and choices as to how and where we invest.

We believe investing goes beyond price-earnings ratios and dividend yields—statistics like these are easily observable. Analyzing Environmental, Social and Governance (ESG) factors offers a measurement system to capture trends that fundamental analysis might underestimate or miss. These factors include environmental stewardship, community impact, gender and pay inequalities, inefficient operations, short-term strategic thinking, and lack of diversity and opinion to name a few. Recent studies1 indicate firms with poor grades in these areas may be exposed to a higher probability of larger than normal drawdowns during times of market stress. On the other hand, high-ranking ESG firms have lower employee turnover, lower borrowing costs, solid financials, diversified board of directors, an above average shareholder and stakeholder focus while, not surprisingly, exhibiting lower stock price volatility. We find highly ranked ESG firms to be “high quality,” which is quantitatively confirmed by a typically higher than average return on equity (ROE).

ESG analysis is sometimes incorrectly characterized as Socially Responsible Investing (SRI). As a comparison, we would say ESG is an inclusionary, factor-driven methodology that aims to identify best-in-class companies in these areas and perhaps a more profitable way to invest. SRI is an exclusionary practice that focuses on an “ethical” (i.e. socially conscious, green, sustainable) investment universe and prohibits certain investments because of a past corporate misstep, accident or manufactured product/service (gun makers, sin stocks, big oil, weapons, fast food, etc.). Utilizing ESG criteria allows for greater choice and, when linked with fundamental analysis, can exploit inefficiencies in the market place that may be the result of a company’s previous mistake, shifting consumer preferences or an unrecognized improvement in a company’s culture.

With that said, does investing in only top ranked ESG companies lead to superior absolute performance? While there are no definite findings on this, we would contend unbiased studies are inconclusive and investing in only top-ranked ESG companies does not necessarily lead to superior absolute performance. However, an overwhelming majority of studies/articles indicate an ESG overlay in the portfolio construction process does generate higher risk adjusted returns especially in “Dividend Oriented” and “Low Volatility” strategies. Higher risk adjusted returns provide a very desirable outcome: less risk for the same return—and if sustainable that would be an extremely important and underappreciated finding. Remember: less risk, less downside volatility increases the likelihood investors stay the course and stay appropriately invested in accordance with their long-term plan.

We firmly believe our younger generation wants to make a difference and will. As these trends continue, we would not be surprised to see some type of premium awarded to top-ranked ESG companies. All of us are familiar with that satisfying feeling we get when we lend a helping hand, do the right thing or make a positive difference. As investment managers, we have the capability to invest in a manner that will give you some of that same feeling by aligning your portfolio(s) with your beliefs. Rewarding firms that “get it” and removing capital from those that don’t may, in addition to giving your portfolio purpose, enhance your risk adjusted performance—an additional welcomed outcome. Should you have a desire for your portfolio to place a greater emphasis on some of your personal beliefs and convictions, please reach out to us.

1 : JP Morgan 12/14/16 Global Quantitative and Derivatives Strategy, MSCI Website: Has ESG Effected Stock Performance and Forbes 6/16/17 article: High ESG Performance Translates Into High Financial Performance