Overview
I previously discussed one of the most popular metrics in investing today: ESG (Environmental, Social, Governance). If you haven’t already, I encourage you to read that article first before continuing to read this one.
In recent years, both retail and institutional investors have started to focus more heavily on ESG when screening potential investments. An increasing number of investors are starting to insist that the enterprises they have in their portfolios must have solid ESG track records, or commit to ESG-related initiatives.
The proponents of ESG-focused investing claim that not only does a focus on ESG promote social good and advance important social causes, but that investors not only help society but also end up having portfolios that tend to outperform the broader market.
I find this claim to be quite debatable. If all it took to beat the market (a task many investors fail to do consistently) was to focus on enterprises with strong ESG, then all it would take to realize superior returns is to pick companies with the best ESG ratings. Becoming a billionaire through investing is now as easy as counting to three. Sounds easy, right?
The Flaw Inherent to ESG
You don’t need to have decades of investing experience to see that ESG is a very subjective metric. Based on my experience, the problem with ESG is that it cannot easily be measured, let alone accurately quantified.
There are hundreds of financial ratios in existence, and almost all of them report a numerical value. Calculating these values is not hard and is usually unambiguous: nearly every investor agrees on how to calculate price-to-earnings (P/E) and net income.
Yet, the problem when it comes to calculating ESG is defining how to measure a company’s environmental, social, and governance performance.
Environmental scores are usually based on quantities of greenhouse gases (GHGs) emitted or the quantity of pollution produced, but social and governance scores are even more challenging to measure.
If a company builds 1000 units of affordable houses or plants 10,000 trees in a year, are they immediately superior to a company that instead chose to spend all their time volunteering at local food banks? If a company has an all-female board of directors, are they immediately superior to a company with a 50/50 division of men and women on the board?
Some companies such as Refinitiv have developed frameworks to calculate ESG, but it is by no means an easy task to perform.
So many investors rely so heavily on a very subjective metric to dictate how their portfolios will look. Investors are quick to shy away from financial ratios and metrics that they don’t understand, so why does ESG get an exemption?
Strong ESG = Superior Financial Performance?
There is no shortage of research that argues ESG-focused investing is financially rewarding, or that ESG investing provides no real additional financial rewards. When a study is published arguing that a focus on ESG leads to better returns, it is only a matter of time until a counter-study is published challenging that notion, and vice versa.
I usually don’t fret over these sorts of studies because chances are the studies performed vary considerably in the methods they used and the variables they worked with.
It’s easy to say, “changes to X, Y, and Z leads to superior financial performance”, and no doubt in due time there will be a counter study that suggests “changes to X, Y, Z does not result in superior financial performance.” The findings of a study are only valid if the observations are replicable – that is, if the study were to be performed by another party, then the exact same outcomes should be observed.
All these studies surrounding ESG don’t lead to any widely accepted conclusions because the experiments performed and the variables defined are all different. One study may define “superior returns” as a constant yearly increase in a portfolio’s market value, whereas another study may define it as increasing total shareholder return over a 10-year period. A study may define “strong financial health” as having abundant free cash flow, whereas another may define it as having low debt levels.
Both proponents and opponents of ESG investing are guilty of performing studies that observe different outcomes by modifying different variables. Until there are several studies that use the same methodologies and modify the same variables, then there will be no consensus as to whether or not strong ESG ratings and strong financial performance go hand-in-hand.
The Purpose of Investing and Business
Many investors caught up in the ESG discussion forget that the whole point of investing can be boiled down to this: putting money down now to get more money later.
Every enterprise, both large and small, share the same objective. In The Personal MBA, author Josh Kaufman offers the following definition of what a business is:
Roughly defined, a business is a repeatable process that: creates something of value, that other people want or need, at a price they’re willing to pay, in a way that satisfies customer’s needs and expectations, so that the business brings in enough profit to make it worthwhile for the owners to continue operation.
The Personal MBA, page 38.
The world’s largest and most profitable companies remain large and profitable because they consistently satisfy this definition of what a business does.
Because of this definition, the argument that ESG immediately makes a business superior to its competitors is debatable. It doesn’t matter if the business is an industry titan like Apple or a local grocery store – as long as they meet the above definition, they will continue to stay in operation.
ESG is not, and will never be, a replacement for bad business fundamentals. A business can have superb ESG ratings, but if they consistently fail to generate a profit then their demise is all but certain. Having strong ESG won’t magically turn a fledgling business into an industry leader.
What ESG-centered investors fail to realize is that strong ESG usually comes from pre-existing strong enterprises. Strong ESG strengthens an already superb business. I have not come across any businesses that put ESG as their focal point then proceed to build around it.
In March 2018, I had the privilege of attending a public lecture given at the University of Alberta by Shell Canada’s President and Country Chair, Michael Crothers. Mr. Crothers mentioned that Shell is traditionally an oil and gas company, and Shell’s strategic focus will continue to be oil and gas. However, Mr. Crothers also mentioned that Shell is slowly becoming a gas and oil company, where the production of gas and other low-carbon energy sources are taking on greater business importance, citing Shell CEO Ben Van Beurden’s goal of making Shell a green energy producer in the coming future.
Even before Shell’s transition to more ESG-centred business activities, they were already, and continue to be, one of the largest oil and gas companies in the world. Shell’s focus on ESG will serve to strengthen its already strong business model, which is its continued focus on oil and gas.
Can ESG improve a business’ financial health? Sure, assuming the ESG-related activities maximize a business’ pre-existing strengths and perpetuates an already profitable business model.
Can ESG make up for a company’s inability to satisfy the definition of a business? Probably not. If a company is already in a precarious financial situation, then the implementation of ESG measures cannot fix their poor business fundamentals.
The Importance of ESG Is Not Equal
How important ESG is when making investment decisions depends entirely on an investor and their investment goals.
I view ESG as a “nice to have” metric. If an enterprise has strong ESG ratings, great. If an enterprise has less-than-stellar ESG ratings, I’m not going to immediately disqualify it for further analysis. ESG is not a metric that will make-or-break my investment decisions.
As a value investor, my goal is to ensure a company’s market value is less than its intrinsic value. That means I place a very heavy emphasis on a company’s financial data. ESG is the last metric I pay attention to, if I choose to pay any attention to it at all, because ESG has no weight when it comes to calculating intrinsic value.
Intrinsic value is usually an estimate of how much a company’s future cash flows will be worth if they were all collected today, a process commonly known as net present value or net present worth analysis. How exactly would ESG fit into this sort of analysis?
So many investors caught up in the ESG frenzy forget that an investment operation must promise two things: safety of principal and an adequate return. If an enterprise cannot satisfy these two criteria, then it is not an investment operation but is instead a speculative one.
Wrapping Up
A recent shift in ESG-focused investing has investors both large and small scrambling to make sure their portfolios are as “ESG friendly” as possible.
ESG is a very subjective metric, so it should come as little surprise that the impact ESG has on a portfolio is inconclusive. Conflicting methodologies and different ways of defining variables have resulted in a lack of clear consensus of whether or not ESG will result in superior returns or will have no effect at all.
I personally doubt that having strong ESG immediately leads to outsized returns. If all it took to become a financially successful investor was to pick companies with an outstanding ESG record, then everyone would be pouring their money into these sorts of enterprises and everyone would be an overnight billionaire.
A strong ESG record is definitely a nice thing to see on a company, but an investment operation must always promise safety of principal and an adequate return. Having strong ESG ratings does not immediately lend an enterprise investment merit.
Photo Attributions
Featured Image – Karsten Würth
Body Image 1 – Jukka Niittymaa
Body Image 2 – Marc Rentschler
