Investing used to be a simpler process; companies traded, there was cash-flow and provided those companies were reasonably well managed and economic conditions were generally favourable, they generated a profit. Beyond that, under strict conditions, companies were permitted to sell shares in their operations. Over time, provided market conditions continued to be favourable and management continued to be effective, the value of those shares stood a good chance of increasing.
Today, the generation of a profit is not the sole guiding metric investors consider. In some cases, companies that have become enormously valuable are loss-making. Their shares have increased in value on mere speculation they will be commercially successful at some point in the future.
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Traditional metrics are joined by new ones
P&L, cashflow and balance sheets have not been abandoned.They are still major investing information anchors and form part of a more complex web of information sources.
ESG is a new dimension that is playing an increasingly significant feature of present-day investing decisions. ESG stands for Environmental, Social, and Governance.
It’s probably fair to say that ESG has its roots in Socially Responsible Investing (SRI) but the evolution to ESG has gained such momentum, it has attracted the ire of some parts of US political leadership. This has resulted in warnings to pension fund administrators and how much significance they place on ESG as they evaluate various investment options.
Investors have been increasingly applying these non-financial factors as part of their analysis process to identify material risks and growth opportunities. What is important to remember is that the application of ESG metrics are not commonly part of mandatory financial reporting. That said, companies have turned to increasingly providing disclosures in their annual reports or in a standalone sustainability report.
Primary ESG factors
First off, it is important to remember there is no single list of ESG criteria. Because of this, it can sometimes be challenging to classify an ESG issue as only an environmental, social, or governance issue, so the list of items in this article should be considered as non-exhaustive.
– Climate change and carbon emissions
– Air and water pollution
– Energy efficiency
– Waste management
– Water scarcity
– Customer satisfaction
– Data protection and privacy
– Gender and diversity
– Employee engagement
– Community relations
– Human rights
– Labour standards
– Board composition
– Audit committee structure
– Bribery and corruption
– Executive compensation
– Political contributions
– Whistleblower scheme
ESG versus SRI investing
As mentioned earlier in this article, the ESG approach to investing grew from an earlier approach referred to as Socially Responsible Investing (SRI). However, there are some key differences between the two. While SRI tends to take a negative approach to firms that fail to meet certain standards of management and so on; ESG on the other hand takes a more positive approach, searching for and identifying potential long-term value in the approach and application of the ESG criteria and ultimately, which companies present a stronger investment potential.
Why ESG matters when investing
There are many reasons why an ESG-led approach to investing is important. One recent example is the European Green Deal which aims to transform the 27-country bloc from a high- to a low-carbon economy, without reducing prosperity and while improving people’s quality of life, through cleaner air and water, better health and a thriving natural world. Increased sensitivity towards social equality have also played a major role in corporate and political actions in the US and Europe in recent years which have accelerated in 2020 leading to organised boycotts of some service providers and brands. Because of this, brands and their leaders are increasingly aware of their own duties and responsibilities from an ESG perspective.
When it comes to making long-term investing decisions, in addition to the traditional financial metrics, it is increasingly important to factor in the ESG approach also. Of course, it is also important to keep the traditional staples of diversification, rebalancing and de-risking in play too to ensure a grounded and solid approach.
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Frank Conway is a Qualified Financial Adviser and Founder of MoneyWhizz, the financial literacy initiative.