October 2016
Equity Investing : Is it as easy as E-S-G ?
Max Cappetta, CEO, Redpoint Investment Management
Investing on the basis of a company’s environmental, social and governance (ESG) practices is a growing trend in financial markets. In dealing with the uncertainty of financial markets, ESG as a stock-selection rule-of-thumb has a certain appeal. However, experience tells us that the investment challenge is never that simple.
In this short article we will consider an investment thesis for incorporating the broader concept of sustainability into equity portfolios. Furthermore, we will highlight some of the risks that various approaches may present and provide ideas for building better investment outcomes.
An investment thesis for “sustainability”
Redpoint believes that economic, environmental, social and governance (EESG) practices of companies can provide valuable investment insight. This view is founded on our investment thesis that EESG, a measure of “sustainability,” offers a new perspective on the quality of company management. Sustainability refers to “good corporate practices” regarding companies’ interactions with the broader economy, the environment and society; and their approach to governance.
Today’s sustainability focus has evolved from investor interest in socially responsible investing (SRI). SRI gained prominence in the 1980’s in response to the anti-apartheid movement advocating divestment in firms engaging in business in South Africa. A longstanding SRI practice is to avoid “sin stocks” such as firms that sell alcohol and tobacco products. Avoiding firms engaged in the production of arms and war material is another ongoing SRI concern. SRI has more recently focused on avoiding firms contributing to climate change.
This has evolved to a focus on firms engaged in non-exploitative, sustainable economic activity. More recently, sustainability criteria have become associated with a wide range of management best practices common among well run, high quality firms; positioned to succeed over the long term.
From “agent” to “stakeholder” theories of the firm
In academia, the evolution of sustainability parallels the evolution of “theories of the firm”. Historically, the “agency theory of the firm” was dominant in economics[1]. Managers were considered agents of the shareholders, hired to manage the firm. To maximize firm value, managers focused on minimising management (or agency) costs. From this perspective, many practices aimed at improving corporate sustainability were viewed as non-essential costs that reduced shareholder value.
Over the last 20 years, the dominance of the “agency theory of the firm” has declined[2]. An extensive literature now documents the importance of good corporate governance practices to maximize firm value[3]. This management literature also documents a growing list of “best practices” important to maximizing profitability and firm value. This evidence has led to the emergence of a new paradigm referred to as the “stakeholder theory of the firm”.
This new paradigm asserts that firm value is maximized by effectively managing the interests, concerns and incentives of all individuals who are stakeholders in a firm’s success – shareholders, management, labour, the environment and society at large. Shareholder wealth is maximized by addressing and motivating all stakeholders to seek the best possible outcome.
A number of examples are often cited such as:
From this perspective, sustainability metrics capture the degree to which a firm addresses stakeholders interests. The stakeholder view posits that good practices are ultimately reflected in superior financial performance.[4]
Incorporating sustainability within your investment approach
Many approaches to incorporating sustainability in equity portfolios are based on a process of exclusion. This naturally stems from a principled position of not wanting to support companies involved in “unacceptable” practices or products.
When considering exclusions based on sustainability grounds, investors should be aware of the risk that such exclusions introduce to their portfolio relative to standard benchmark portfolios. In some instances, the risk may be irrelevant and, based on principle, investors should simply reset their “benchmark” to include only those companies that pass their sustainability tests. Alternatively, investors may consider a more activist approach. This could entail holding a below benchmark position in poorer rated companies and then using this shareholding to lobby management to make changes to its practices.
Whether investors exclude or down weight there remains ample scope for active management to be overlaid to build new investment strategies. At Redpoint we believe that a range of investment disciplines can be applied to an investment universe of better EESG-rated companies. Successfully meeting multiple investment objectives is not easy but certainly possible. Investors should clearly understand the interactions between
Easy as E-S-G?
While “E-S-G” sounds straight forward, there are implications for investors that make it anything but easy. These issues can be overcome and sustainability can be made to play a role working in concert with well accepted and proven investment approaches.
In this short article we will consider an investment thesis for incorporating the broader concept of sustainability into equity portfolios. Furthermore, we will highlight some of the risks that various approaches may present and provide ideas for building better investment outcomes.
An investment thesis for “sustainability”
Redpoint believes that economic, environmental, social and governance (EESG) practices of companies can provide valuable investment insight. This view is founded on our investment thesis that EESG, a measure of “sustainability,” offers a new perspective on the quality of company management. Sustainability refers to “good corporate practices” regarding companies’ interactions with the broader economy, the environment and society; and their approach to governance.
Today’s sustainability focus has evolved from investor interest in socially responsible investing (SRI). SRI gained prominence in the 1980’s in response to the anti-apartheid movement advocating divestment in firms engaging in business in South Africa. A longstanding SRI practice is to avoid “sin stocks” such as firms that sell alcohol and tobacco products. Avoiding firms engaged in the production of arms and war material is another ongoing SRI concern. SRI has more recently focused on avoiding firms contributing to climate change.
This has evolved to a focus on firms engaged in non-exploitative, sustainable economic activity. More recently, sustainability criteria have become associated with a wide range of management best practices common among well run, high quality firms; positioned to succeed over the long term.
From “agent” to “stakeholder” theories of the firm
In academia, the evolution of sustainability parallels the evolution of “theories of the firm”. Historically, the “agency theory of the firm” was dominant in economics[1]. Managers were considered agents of the shareholders, hired to manage the firm. To maximize firm value, managers focused on minimising management (or agency) costs. From this perspective, many practices aimed at improving corporate sustainability were viewed as non-essential costs that reduced shareholder value.
Over the last 20 years, the dominance of the “agency theory of the firm” has declined[2]. An extensive literature now documents the importance of good corporate governance practices to maximize firm value[3]. This management literature also documents a growing list of “best practices” important to maximizing profitability and firm value. This evidence has led to the emergence of a new paradigm referred to as the “stakeholder theory of the firm”.
This new paradigm asserts that firm value is maximized by effectively managing the interests, concerns and incentives of all individuals who are stakeholders in a firm’s success – shareholders, management, labour, the environment and society at large. Shareholder wealth is maximized by addressing and motivating all stakeholders to seek the best possible outcome.
A number of examples are often cited such as:
- effective management of environmental impacts to mitigate costly regulatory shocks;
- safe working conditions and fair wages to improve labour productivity;
- building customer loyalty and brand value via community wide service and engagement; and
- having effective governance structures to aid decision making and overall firm management.
From this perspective, sustainability metrics capture the degree to which a firm addresses stakeholders interests. The stakeholder view posits that good practices are ultimately reflected in superior financial performance.[4]
Incorporating sustainability within your investment approach
Many approaches to incorporating sustainability in equity portfolios are based on a process of exclusion. This naturally stems from a principled position of not wanting to support companies involved in “unacceptable” practices or products.
When considering exclusions based on sustainability grounds, investors should be aware of the risk that such exclusions introduce to their portfolio relative to standard benchmark portfolios. In some instances, the risk may be irrelevant and, based on principle, investors should simply reset their “benchmark” to include only those companies that pass their sustainability tests. Alternatively, investors may consider a more activist approach. This could entail holding a below benchmark position in poorer rated companies and then using this shareholding to lobby management to make changes to its practices.
Whether investors exclude or down weight there remains ample scope for active management to be overlaid to build new investment strategies. At Redpoint we believe that a range of investment disciplines can be applied to an investment universe of better EESG-rated companies. Successfully meeting multiple investment objectives is not easy but certainly possible. Investors should clearly understand the interactions between
- their own principled position with respect to sustainability
- their investment thesis of the return opportunity of focusing on sustainability, and
- other investment characteristics investors are seeking.
Easy as E-S-G?
While “E-S-G” sounds straight forward, there are implications for investors that make it anything but easy. These issues can be overcome and sustainability can be made to play a role working in concert with well accepted and proven investment approaches.
Footnotes
[1] Jenson, M. and Meckling W., “Theory of the Firm: Management Behaviour, Agency Costs and Ownership Structure”, Journal of Financial Economics 3, 1976
[2] Stout, L., “New Thinking On Shareholder Primacy”, UCLA School of Law, Law-Econ Research Paper No. 11-04, 2011
[3] Ammann, Oesch and Schmid (2010)
[4] Hillman A. and Klein G. 2001
[1] Jenson, M. and Meckling W., “Theory of the Firm: Management Behaviour, Agency Costs and Ownership Structure”, Journal of Financial Economics 3, 1976
[2] Stout, L., “New Thinking On Shareholder Primacy”, UCLA School of Law, Law-Econ Research Paper No. 11-04, 2011
[3] Ammann, Oesch and Schmid (2010)
[4] Hillman A. and Klein G. 2001
Important information : This communication is provided by Redpoint Investment Management Pty Limited (ABN 83 152 313 758, AFSL 411671) (Redpoint). The information in the communication is of a general nature only and is not financial product advice. The communication is not intended to offer products or services provided by Redpoint or its affiliates. Opinions constitute our judgement at the time of issue and are subject to change. Neither Redpoint nor its employees or directors give any warranty of accuracy or reliability, nor accept any responsibility for errors or omissions in this communication.