Making investment decisions by focusing on issues beyond balance sheets, income statements, and other measurable metrics has become a major issue in the finance world. ESG (Environmental, Social, and Governance) is the movement aimed at incorporating other factors into the investment decision process. Those in favor of using ESG factors as part of the investment decision-making process argue that it not only improves the world as we know it but produces better investment returns over time because those companies with higher ESG scores have superior investment returns. Those who cast a skeptical eye to using ESG measures as part of the investment decision-making process are focused on the traditional metrics of balance sheet, income statements, absolute and relative valuation to determine if the stock or bonds of a particular company represent an attractive investment opportunity.
How does ESG work:
Traditionally investment professionals evaluate a potential investment based on a combination of financial analysis, relative valuation, and estimates of future growth of the entity being evaluated. The inclusion of Environmental, Social, and Governance factors (ESG) in the investment decision-making process is a recent phenomenon. The philosophy behind the inclusion of these factors in the investment selection process is based on the belief that choosing investments/companies with higher ESG scores will, in the long run, produce superior investment returns. Because ESG investing is relatively new, the process of measuring these factors and assigning scores to different companies is an uncertain process. This process is made even more difficult by the fact that determining an ESG score for a particular company is a subjective process – the ability to quantify most ESG measures is difficult and fraught with pitfalls. To illustrate the difficulty of establishing an ESG score for a given company, look no further than the fact that Silicon Valley Bank (SVB) and FTX both had higher ESG scores than the vast majority of companies in the S&P 500 when they failed.
What is the role of corporations in a market economy:
In a market economy or capitalistic economic system, corporations are entities that arise because of economic efficiencies that are gained by organizing the factors of production using the legal structure of the corporation. Once a corporation is created, its primary and overriding goal is to maximize return to shareholders. Achieving the goal of maximizing shareholder return is the job of the CEO and other members of the management team. If a management team is distracted from this goal and shareholder return suffers as the result, shareholders typically exercise their voting power by making management changes. The corporate graveyard is littered with failed corporations whose management teams became distracted by peripheral issues, and the fortunes of the company suffered as a result. One of the risks to using ESG factors in the investment selection process is that management takes their eye off the ball, and the company’s fortunes suffer as a result.
What is the future of ESG:
Based on broad support for using ESG factors in the decision-making process, it is likely ESG is here to stay. What will likely happen over time is that the use of ESG factors will evolve as more data becomes available and the factors are refined in a way that the metrics become more quantitative and, as a result, easier to measure their impact on investment returns. In the interim, we believe a continued focus on fundamental analysis – balance sheets, income statements, relative valuations and projections of future performance will dominate the investment process. At Trajan, we believe investors should continue to focus on the things that have worked in the past and what we expect will work in the future. Warren Buffett – the Oracle of Omaha – was recently asked if Berkshire Hathaway used ESG in their investment decision-making process and the answer was an emphatic “No.” We are of the same view, but open to change as the process becomes more refined, measures become quantifiable, and evidence of superior returns for applying ESG factors becomes evident.
Sterling Russell, CFA