By Chat Reynders
The notion that environmental, social, and governance (ESG) analysis is a complement to – not a substitute for – fundamental security analysis is nothing new. However, ESG has now become a buzzword and a check-box across much of the investment industry. More investment products and managers are touting the fact that ESG and other sustainability criteria are considered in the investment process to attract the growing pool of investors interested in making an impact.
ESG analysis should not be easy. It is a discipline rooted in the fact that making an investment decision is about more than analyzing numbers – it is about understanding how non-financial factors hinder or complement company performance. But today, the vast majority of ESG’s application comes in the form of applying quantitative ratings and rankings to screen out prospective investments that do not meet predetermined criteria.
Isolating ESG metrics and relying on their ratings and rankings alone may be risky. Not only is it a dramatic oversimplification, but it also fails in terms of how ESG analysis can be used effectively to identify companies that deliver on both sustainable earnings growth and positive social and environmental impact.
Importantly, the check-box approach jeopardizes the momentum that socially responsible investing (SRI) has achieved over the past decade. Exclusionary screening is not an investment discipline; it is a simple way for investors to respond to social and environmental concerns and is the primary reason that traditional SRI failed to gain traction. In an effort to avoid association with exclusionary screening, some managers are claiming to only invest in “best in class” ESG performers. Those that follow this approach still fall short when it comes to uncovering climate change and other sustainability-related information needed to determine risk and opportunity in stock evaluation. Here is why:
1. The data is imperfect:
Currently, there is no regulation concerning the disclosure of ESG issues. Although organizations such as the Sustainability Accounting Standards Board (SASB) are working to address standardization and materiality, inconsistencies across ESG data providers and researchers remain. For example, a CSRHub analysis found a wide discrepancy between the sustainability ratings provided by MSCI and Sustainalytics, two leading ESG research firms (Reuters).
2. Data looks backward, not forward:
ESG data, ratings, and rankings are creating unjustified confidence primarily based on what a company has done in the past. As investors, however, we want to know how a company views ESG factors now and how consideration of these factors will impact the company and its financial performance in the future.
3. Materiality is lacking:
As corporate social responsibility (CSR) has become commonplace, companies are getting more savvy about what to report. Publishing information that sheds a company in the best light possible in relation to ESG criteria neglects other information – both positive and negative – and fails to address issues that may be more material to a company and its business.
What is the solution? At Reynders, McVeigh, ESG data and analysis is a starting point, not an endpoint. It gives us an idea of where we need to focus our research, do more digging, and, most importantly, develop the right questions for both good and bad performers. We are more interested in where a company is going than where it is coming from.
The most daunting concern is that ESG is strictly being used as a quantitative tool. If investors are not investigating the qualitative questions behind the data, they simply are not doing a good job when it comes to ESG. The right questions help investors understand how a company’s financial statements align with its ESG activities. For example, if a company promotes its purpose as creating innovative technologies to mitigate greenhouse gas emissions, but has only allocated 2% to research and development – it does not add up. Similarly, a small or mid-cap company that is doing great things may receive poor ESG scores because it does not have the resources to report, or has not yet determined the best way to report compared to larger companies.
Asking the right qualitative questions is hard, but it is paramount for building a relationship with management to understand the DNA of a company and its plans moving forward. Questions differ across industries, companies, and material issues, but primarily address:
While ESG information is improving, the data is only useful in the context of a thoughtful investment discipline. As is true with any productive research process, investors need to understand that ESG information is merely the starting point for forming the kind of critical questions that can lead to valuable insights.
Chat Reynders, Chairman and Chief Executive Officer of Reynders, McVeigh Capital Management LLC., has more than 25 years of experience in investment management and social venture investing. He has structured and funded public/private partnerships that have brought more than $150 million in revenues to leading cultural institutions. He has for decades produced socially oriented IMAX films, including the Oscar-nominated Dolphins and Coral Reef Adventure. Chat's focus on climate change also led him to his current role as a Director on the Board of the MacGillivray Freeman Educational Foundation (MFEF), an organization committed to increasing awareness of the delicate state of our oceans and environment. He also serves on the board of directors of the Westminster Kennel Club, and the Brookwood School.