There are a variety of different investing philosophies within the realm of sensible investing. One method that is becoming increasingly important is ESG investing. The acronym “ESG” stands for environmental, social, and governance. ESG criteria is now being used more and more alongside financial factors in the investment decision-making process by the professional investment community. In this paper we will define what ESG is, give you some background on its origin, how it evolved for today and why it should matter to C-Suite executives. We’ll also give you some guidance on how to begin to consider socially conscious investing and set up guidelines in your company’s corporate governance.
In recent years, the actions many companies take to maximize profit have become more difficult to separate from the social issues they directly influence—including global warming, pay, gender equality and human rights. Companies can even be judged based on their influence and contributions to certain causes or in their local communities.
The Origins of Socially Conscious Investing
The practice of ESG investing began in the 1960s as socially responsible investing, with investors excluding stocks or entire industries from their portfolios based on the arguably “unethical” and potentially harmful for greater society sources of their revenues, such as tobacco production, firearms, or involvement in the South African apartheid regime. In recent years the surging popularity of ESG investing stems from investors targeting stakes in companies that reflect their overall sustainability values, which incorporate ethical aspects of their business. Investors are increasingly aware that their capital is helping to shape our future and they want companies to be held accountable as good corporate citizens, as well as the proper stewardship of their capital.
Though not part of a financial analysis, many investors feel that these factors may have direct impact on key financial inputs. Research has increasingly shown that such integrated reporting can reduce portfolio risk, generate competitive investment returns, and help investors feel good about the stocks they own. It’s no wonder ESG investing is gaining traction.
What is ESG?
ESG is an acronym for its three components: Environment, Social, and Governance.
How is the company affecting the key natural environment elements – water, air, and earth / land and on complying with government regulations? How does it address environmental risks or handle pollution that may occur as a result of its business? Note that among the many ESG factors that are viewed as having financial relevance are those related to climate change. The degree of care became elevated over the years because data shows that climate change is no longer a distant threat on the horizon, but one that is here upon us, with multi-billion-dollar economic consequences and potential to permanently alter our environment.
How does the company invest in its human capital and participate in the overall community? What kind of degree of care is being exercised with respect to customer privacy, data security, content management. How does the company build relationships in the community? does it ethically deploy its solutions, such as AI, without negatively impacting employment or generating productivity without tax contributions that would otherwise occur by employed and salaried labor? This segment also analyzes corporate impact on human rights, ethical treatment of human resource labor, career development, as well as creation of jobs domestically vs. overseas.
Corporate Governance Pillar
The corporate governance component relates to leadership and governance, such as independence and diversity of corporate board of directors, quality of company oversight, as well as a shareholder-friendly versus management-centric attitude. How does it handle opposition from stakeholders? It also includes company’s shareholder voting policies, executive pay, accounting practices and the gender and racial diversity of a company’s board. This segment also examines the entire business model and the strategy of the enterprise. For example, does the company’s supply chain including the factories, plants operate with the same ethical standards as those touted by the company? What about product liability? How safe is the product that the company produces and what potential harm material components may cause its end customers, from health hazards to loss of productivity. ESG investors are focused on whether corporate incentives align with the business’s success.
The “Trump Bump”
Some think ESG’s boom is a response to the election of Donald Trump, who has rolled back environmental protections and vowed to withdraw the U.S. from the Paris Accord. Thanks to the “Trump Bump,” ESG mutual funds and ETFs (exchange-traded funds) began growing at three times their usual rate a month after the 2016 election, increasing from $95 billion to $118 billion under management in a year. Today, socially conscious investing is estimated at over $20 trillion in AUM1 or around a quarter of all professionally managed assets around the world, and its rapid growth continues to build on the Socially Responsible Investment (SRI) movement we talked about earlier.
Why Should Small-Caps Care about Socially Conscious Investing?
Historically ESG issues have resided squarely in the realm of mid- and large-cap companies and their investors. It is becoming clear that ESG is quickly evolving from a “nice to have” to a “must have” in companies that aim to attract reputable long-term shareholders. Funds like BlackRock and State Street are at the forefront of ESG reporting, reporting standardization and comparability efforts. They are encouraging companies to report on issues that impact our planet, our lives, and in turn, success of our businesses, which is operating not in the vacuum but in the very ecosystem it is affecting. What goes around, comes around is not just a proverb anymore. The impact across ESG matters impacts the bottom line and thus, valuations.
As is often the case in capital markets, what investors are scrutinizing in bigger market cap companies often makes its way to smaller companies. ESG measures are becoming a valuable tool for evaluating the financial performance of smaller companies. Analysts point to the fact that small-cap firms with a high sustainability ranking tend to outperform lower scoring peers. A BofA Global Research report recently noted that small caps with available higher ranking ESG scores have been trading at a growing premium to low-ranking small caps.
We think that for small-cap companies, now might be the time to start understanding ESG. Companies that can show investors they are ahead of the curve — reducing climate-related risks in supply chains, upholding strong governance norms, and reducing workplace inequality, for instance — will likely fare better when investors may start to focus on these issues.
Here are some steps that small-cap companies should begin considering:
Make sure you understand if and how your current investors are thinking about ESG.
- When you meet with prospective investors, inquire about whether ESG is part of their capital allocation decision-making processes.
- For boards of directors, taking the broad issues of sustainability and breaking them into pieces to identify which particular pillar – E, S, or G will MATERIALLY impact each specific company segment, and how that translates into a financial impact to assets, liabilities, risks or profits and losses.
- From there, the board and management team should understand potential risks related to each issue deemed material or significant. The board can review an adopted set of metrics, several times a year to gauge over time how it is faring.
- Companies that can show investors that they’ve assessed their business risks and operations through a socially conscious investing lens and can meaningfully communicate their risks and opportunities with metrics, data, and information, will likely be more attractive to investors.
- Not all issues related to ESG will be material for all companies, but boards should ensure the management team has carefully considered those that are, and those that aren’t.
Regardless of a company size, many investors are focusing on ESG, because they believe it will improve long-term shareholder value. Research is increasingly showing that this investing method can reduce portfolio risk, generate competitive investment returns, and help investors feel good about the stocks they own. Key stakeholders are realizing that strong ESG traits can be viewed as indicators of companies with exemplary management teams. A well-defined ESG ethos demonstrates long-term thinking, and the ability to consider positive future outcomes showing clear vision.
Finally, the pandemic and social justice issues will most likely move the ESG agenda forward, even for small- cap companies. In addressing the COVID-19 crisis, companies have been compelled to focus on all stakeholders (employees, customers, bankers, regulators and vendors) and not just investors. Companies are now paying closer attention to human capital issues like diversity, inclusion and equality. It’s not just about shareholder value, it’s about stakeholder value and communications. Today, socially conscious investing has matured to the point where it can greatly accelerate market transformation for the better.
Greg Falesnik is Chief Executive Officer of the MZ Group North America, the world’s largest independent investor relations and corporate communications firm. To learn more about MZ Group and its ESG iQ platform, please visit www.mzgroup.us or contact Greg Falesnik at email@example.com.