Long-term, performance-focused investors must carefully consider the challenges and opportunities that may impact businesses in the decades to come. If it were easy to do this, though, it would be automatic by now. Exploring a giant swath of data points, tactics, strategies, and heterogeneous information is simply a large body of work. It also compels a good deal of humility, an acknowledgement of luck, and a desire to always learn more and to turn over more rocks, and to look at more information in order to arrive at investment insights.
Yet a whole slew of relevant environmental, social, and governance-related information has been panned by political agendas that are far removed from the purview of investment managers. Acronyms can sometimes be helpful, but in the U.S. the term ESG has come to mean everything from greenwashing and shortcuts, to saving the planet.
Our use-case at Brown Advisory for environmental, social and governance information, however, can be vastly different from how some clients, regulators, and other stakeholders use the term. Here is an attempt to invoke fundamental investing basics to clarify exactly what we aspire to deliver for our clients.
An unassuming shorthand (from 20 years ago)
A 2004 report published by the United Nations is often given credit for popularizing “ESG” as a shorthand for the myriad issues in environmental, social, and governance categories. It is instructive to re-visit the title and a key take-away, endorsed by the UN and financial institutions from nine countries with $6tn of assets under management at the time (italic emphasis mine):
“Who Cares Wins: Connecting Financial Markets to a Changing World”
The institutions endorsing this report are convinced that in a more globalised, interconnected and competitive world the way that environmental, social and corporate governance issues are managed is part of companies’ overall management quality needed to compete successfully. [1] Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate. Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value.
The origin story of the term “ESG” therefore directly ties environmental, social, and governance know-how to:
- management quality,
- competitive position,
- risk management,
- shareholder value,
- new markets (growth), and
- brand reputation.
All of these potential outcomes of a company’s ability to manage its environmental, social, and governance issues should be of interest to investors. The report posits that these outcomes can “at the same time [contribute] to the sustainable development of the societies in which they operate.” In other words, investors prioritizing strict fiduciary duty could focus on ESG information in an effort to make better investment decisions; if other stakeholders are interested in sustainable development, that’s also a win. But ESG information is just that: information. It is not an action nor a movement nor a political statement.
Performance: the signal amidst the noise
Environmental disruption from climate change could be felt in every sector, and investors should benefit from understanding whether companies are being proactive or reactive. Whether it’s elevating key equipment in order to protect coastal infrastructure, or keeping employees safe during extreme heat waves by investing in climate-controlled facilities, or finding alternative agricultural commodities where supply chains are stressed, every business will likely be challenged in one way or another.
Social factors such as access to healthcare, food, and housing can create meaningful risks and opportunities that are directly relevant to a company’s competitive position. Companies that can better manage human capital and support the people and communities surrounding the organization will likely win amidst changing employee, customer, and regulatory expectations around the globe.
Governance agendas are broadening to address consumer and investor pressures and expectations. Directors and corporate leadership are accountable well beyond mere compliance to address issues of transparency, trust, ethics, diversity and inclusion, and stakeholder engagement. Without strong governance and accountability, investors can experience some dismal results (think Wells Fargo or Volkswagen).
In short, the E, the S, and the G matter to performance-focused investors because elevated risks (and the associated opportunities) can lead to winners and losers. It follows that all of these issues should be incorporated into security analysis.
Opportunities
At Brown Advisory, we dive deep into many of the environmental, social, and governance risks mentioned above as part of our due diligence to understand a company’s fundamental financial drivers and future prospects for performance. As there's no shortage of such risks, we also find opportunities to solve these intractable challenges across the entire economy. For example, companies can help their customers save energy (by moving computing workloads to the cloud), save lives (by enabling therapeutic innovations such as cellular genomics), or improve lives (by bringing billions of underbanked populations around the world into the global financial system).
This approach is consistent with active, performance-focused investing principles. Any qualitative or quantitative investment insight, isolated from company fundamentals, is like talking about free cash flow (FCF) in a vacuum - FCF is less interesting if a company doesn't make good capital allocation decisions or reinvest in the business. By the same token, considering ESG criteria as a separate exercise from a fundamental, financial underwriting process is less helpful to investment insights compared to a holistic view of investment risks and opportunities.
The noise
It has been remarkable to observe that the common-sense approach of considering a whole host of risks and opportunities in an investment process has been pegged to an acronym, ESG, that is a useful shorthand in theory, but has become so ambiguous as to be vulnerable for appropriation along narrow ideological lines.
Some now warn that ESG investing contradicts fiduciary duty because it is practiced for the sole purpose of effecting social and environmental impacts. The term has also been appropriated by fossil-fuel protectionists in the United States with the claim that investment portfolios that limit fossil fuel exposure are anti-competitive (for allegedly colluding to boycott investments in fossil fuel companies). ESG legislation is winding its way through political processes in many U.S. states. ESG has often been described as a "movement" in the media. These agendas can fail clients, who have the prerogative to direct how their capital is allocated.
The practical experience of institutional and retail investors alike has been hit-or-miss with, on the one hand, several successful, market-beating investment funds[2], and on the other hand a proliferation of ESG products, some of which have now famously been lambasted by whistle-blowers as fraudulent[3],[4].
Because ESG is just a set of loosely structured (or unstructured) information that means different things to different stakeholders, controversies were almost inevitable. Regulators may need ESG data such as occupational safety and health violations or chemical discharges. Clients who seek to avoid certain industries will regularly seek nonfinancial data. Consumers may demand disclosures in order to assess a company’s marketing claims. Some activists use ESG criteria to buy shares and attempt to force change via shareholder proxy resolutions. And others are performance-focused investors, who use ESG information as part of a holistic due diligence process.
If such wildly different results are expected from one ill-defined term, no wonder political agendas can take over the message. It is safe to say that because messaging around ESG has become so polarized, the vast majority of references to “ESG investing” stand in stark contrast to what performance-focused, active, high-conviction investors do.
Can we all agree on performance?
To cut through this chaos, at Brown Advisory we trust that a focus on performance is where we can agree (at least with our clients).
For our Large Cap Sustainable Growth strategy, the very word “sustainable” can help clients situate our approach. We believe in two meanings for the term “sustainable”: both durable growth (we expect companies and their investors to be rewarded for good work), and “sustainable development” (meeting current needs without sacrificing the ability for future generations to meet their own needs). Isn’t that a fiduciary’s responsibility to clients who have an objective of long-term performance?
To deliver on performance for clients, we rely on a long-standing and successful investment process that does indeed incorporate a lot of environmental, social, and governance information.
No shortcuts
Here’s a perspective on ESG: a label illuminates very little, if anything at all, about an investment approach. It’s like expecting a map to always precisely guide the way. Its usefulness depends on where you want to go, and on whether the navigator has other skills and tools such as orienteering, a compass, or a car. A map is just one of many tools to get you where you want to go, just like a balance sheet is not a complete picture of financial health.
A label such as ESG – or other shorthand labels such as growth or value for that matter – does not dictate a homogeneous investment process. Jumping to conclusions about an investment approach based on a label is antithetical to the intellectual curiosity and hard work that are hallmarks of active management.
As stewards of our clients assets, we take great effort to answer an expanded set of questions about companies to understand if a business is getting stronger, if it has high barriers to entry, if it can attract and retain the right talent, if it has a high-quality management team, if it is doing more with less, and if it is prepared for a world with greater challenges and fewer resources. One could call these ESG issues, or fundamental opportunities, or existential risks. Our results over time have benefited from the fact that we look for information and review data sources that many other investors may ignore.
We hope that communicating this approach without using shorthand terms such as ESG can re-set any expectation that there are shortcuts to finding and making use of information that eludes standard financial disclosures. Every active, fundamental, and high-conviction investor knows that every company and every situation is unique, and investing requires intense and creative research to parse a wide swath of information, and hopefully make winning decisions more often than not.
1https://www.unepfi.org/fileadmin/events/2004/stocks/who_cares_wins_global_compact_2004.pdf
2https://illuminem.com/illuminemvoices/implications-of-the-outperformance-of-active-sustainable-investing
3 https://www.cnbc.com/2021/08/24/blackrocks-former-sustainable-investing-chief-says-esg-is-a-dangerous-placebo.html
DISCLOSURES
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned.
Sustainable investment considerations are one of multiple informational inputs into the investment process, alongside data on traditional financial factors, and so are not the sole driver of decision-making. Sustainable investment analysis may not be performed for every holding in the strategy. Sustainable investment considerations that are material will vary by investment style, sector/industry, market trends and client objectives. Certain Strategies (“Strategies”) seeks to identify companies that it believes may be desirable based on our analysis of sustainable investment related risks and opportunities, but investors may differ in their views. As a result, the Strategies may invest in companies that do not reflect the beliefs and values of any particular investor. The Strategies may also invest in companies that would otherwise be excluded from other funds that focus on sustainable investment risks. Security selection will be impacted by the combined focus on sustainable investment research assessments and fundamental research assessments including the return forecasts. The Strategies incorporate data from third parties in its research process but do not make investment decisions based on third-party data alone.
Free Cash Flow is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.