With all the risks in the financial markets, there is one type of risk that many of us tend to ignore. It can also present opportunities.
This is the Social Environment and Governance, or ESG. When selecting investments, it is everyone’s business. Businesses with less risk can also present opportunities that you miss.
Not for you? Even if you don’t identify with ESG, let’s get back to political opinions or moral judgments. In fact, this is part of the assessment of significant risks and opportunities. It is an integral part of the analysis of growth, valuations, strategic advantages and the business model of any company. Consider that these are everyone’s problems, not just people on one side of the political aisle, from a partisan perspective, or those who identify in a particular way. On the positive side, integrating ESG into portfolio management potentially maximizes risk-adjusted returns over the long term. It does this by using ESG factors as one of the components in assessing the long-term viability and potential benefits of a business.
Many ESG issues arise from inadequate or misaligned corporate governance, the âGâ in âESGâ. Governance is the set of standards that a company can put in place to ensure the effectiveness of the board of directors and the quality of management. This high-quality management can translate into greater transparency in accounting practices, fair compensation for executives and other determinants of long-term economic success.
If companies practice and maintain better corporate governance procedures, management may tend to make better decisions. Many of these decisions take into account shareholders, as well as employees and the community. This is the bright side. However, if policies favor the interests of management over those of shareholders, there is a clear downside risk.
Suppose a CEO (who is also the chairman of the board) appoints the board of directors, which is responsible for overseeing management. As a shareholder, you can receive proxies by mail or online, in which you are asked to simply endorse the choice of directors by management.
The outside directors, not the management of the company, are elected to provide an independent perspective and arm’s length accountability. What if the objectivity is questionable, such as when even outside directors are management’s buddies? There appears to be a conflict of interest, as management should be accountable to the board!
In some cases, CEOs may bring in board members who are financially dependent on their attendance fees to maintain their lifestyle. They become ârubber stampsâ for the CEO. So if management âpacks the board,â how effectively does that board protect your interests as a shareholder?
Hopefully this demonstrates the need for portfolio management that assesses the effectiveness and independence of the board. How many directors are outside directors? What are the selection processes in place? ESG integration as a factor in stock picking can help identify potentially successful companies, as opposed to those with conflicts of interest.
Think of mergers and acquisitions as events with potentially disproportionate upside or downside consequences. Large mergers (as opposed to small strategic mergers) often fail to generate the expected synergies and cost savings. Often this is due to a mismatch between corporate cultures and management styles. In addition, such large mergers often dilute the company’s stock and increase the debt load. Is management striving to add value or just build a bigger empire?
Inadequate board effectiveness can also interfere with the way management and the board handle decisions about cash and stocks. Companies may resort to share buybacks that decrease the free float, or supply, of publicly traded shares. Buybacks can be used to improve financial structure and achieve long-term goals, they can also be used simply to produce short-term price gains, to optimize the exercise of stock options and the allocation of shares by management.
Take the example of a very cyclical company that uses a lot of its cash to buy back its own stock, rather than paying down debt or reserving for economic cycles or setbacks. When business conditions become difficult and threaten the survival of the business, investment performance suffers. Plus, the resulting government bailout forces you, as a taxpayer, to subsidize the business!
Are these issues close to your heart? Then think about corporate governance.
See this as a way to differentiate companies with improved long-term stability and superior performance from those that underperform.
Employee Relations are a social issue that can be influenced by good governance. For many years, studies have shown that companies with superior employee benefits and a positive work environment exhibit superior retention of talent or human capital. So let’s consider Employee Relations as a factor in evaluating our universe of values ââfrom which to choose.
Take the case of a company that we will call Acme. Management was asked why so much of their permanent workforce worked less than 20 hours per week, with no benefits, and relied on Medicaid. Management responds that without Acme these employees would likely have no jobs at all! Sounds a bit like “Let them eat cake” from Marie-Antoinette, doesn’t it? (You know how it worked!) As a shareholder, there are unfortunate consequences, often referred to as âoverall riskâ, that can lead to serious risks to your investment.
The viability of the company is also a consequence. As an Acme shareholder, do you think low paid employees without benefits are fully engaged, efficient and loyal? A high turnover rate costs you, as a shareholder, every time an employee leaves to find a job with a living wage and benefits.
So, Governance and Social Relations are your challenges? Do you want Acme in your portfolio, or its most effective business and human capital competitor, which hires its people and drives them to perform better?
You can also consider the social costs. Employees who cannot live on their low wages without health care impoverish your community with a variety of economic and human costs? Because to add insult to injury, who pays Medicaid for these uninsured employees? You do it as a taxpayer!
Think about the environment. Do you want to own shares in a company that suffers from litigation, fines and negative publicity resulting from poor environmental decisions? Or do you want to own a business that competes effectively with less conscientious businesses? Again, your portfolio manager can and should differentiate between the potential downside risk and the potential upside opportunity. This is all part of the assessment of significant risks and opportunities.
So what do we see in terms of material benefits for our customers?
My team and I find that our best independent portfolio managers tend to have, among other characteristics, ESG guidelines in place. We define âbest managersâ as those who exhibit superior long-term returns relative to the level of risk they take. Risk management is the most important part of their job. Incorporating ESG guidelines into stock selection can help identify companies with competitive advantages in the market. It can help those who are at downside risk. Making this distinction can lead to superior long-term absolute and relative performance.
Increasingly, here’s a side effect: in financial markets, perception is reality. Companies that are seen as having best practices may increasingly be seen as better âbuyersâ than those that need to add discipline to their policies and practices.
These are just a few of the issues encompassed by an investment discipline influenced by ESG factors. You can have personal priorities. Separately managed accounts allow direct ownership of businesses. Your portfolio can reflect your values ââand priorities, and you have the flexibility to select entire companies or industries accordingly. Your advisor and the asset managers they employ on your behalf may be sensitive to your concerns and the success of your long-term goals.