"Sustainable" Investing: Rewards and Challenges

The investment approach has various labels, including "sustainable," "responsible," and "ethical" investing.  Or, it is known as ESG investing, where conventional investment analysis is combined with a company's environmental, social, and governance practices.  Regardless of the label assigned, it means investing with an emphasis on companies with managements that are progressive with respect to making useful products and minimizing the harmful environmental consequences of the business operations, fostering positive employee and community relations, and practicing high ethical standards.  A growing number of pension and endowment funds have embraced sustainable investing.  


It's easy to see why.  First, investing in progressive companies has the effect of reducing risk without sacrificing returns, and it is often consistent with the missions of such funds. Companies that are progressively managed relative to their competitors have less risk of legal or regulatory problems, resource scarcity, and they have greater business opportunities. 


Such companies are simply better managed, and they deserve higher valuations in the stock market.  Their stocks also have produced superior returns to market indexes, and even greater returns compared to their competitors who are rated poorly on ESG measures.  These better-managed companies are more "sustainable," in that they are more likely not only to survive over time, but to excel relative to competitors.


Research firms specializing in ESG investing provide qualitative assessments of the largest publicly traded companies, and quantitative scores and rankings as well.  Various publications and online sources also provide pertinent ESG information and rankings of companies.   


There are, however, challenges in taking a sustainable investing approach.  It is difficult to assign a rating or ranking to large enterprises that operate in various industries with operations around the world.  Some regions or business divisions may have exemplary records, while others within the same company might not.  Many companies, for example, operate in industries that have harmful environmental effects, such as mining or energy.  How much emphasis should be given to managements' good intentions at improvements on ESG measures and how much to the actual effects of the operation of the business?


For these reasons, for the largest global companies, there are varied rankings on ESG measures for the same company, depending on the firm that has done the analysis.  There are, however, a group of companies that tend to appear at the top of global rankings nevertheless (as well as a group of companies at the bottom).


In contrast to approaches from a decade or two ago in which investors would simply avoid entire industries that were major polluters, for example, most sustainable or responsible investment firms now engage company managements to try to alter company practices in a positive way and give credit to companies that try to improve on this score.  That is where the emphasis should be placed, favoring those at the top of global company rankings and avoiding those toward the bottom.  


Two recent examples show the challenges for research firms and investors to fairly assess the conduct of companies.  GlaxoSmithkline for some time has been near the top of most rankings of sustainability.  Yet, the company recently was assessed a fine of the extraordinary amount of $3 billion for improper marketing of some of its drugs.  That was clearly unethical behavior, but does that negate the good the company has done on other measures?  And how does Glaxo compare to other pharmaceutical firms?


Similarly, the U.K. bank HSBC consistently has been near the top of most sustainable investment rankings.  But the bank recently was accused of money laundering for Mexican drug cartels.


While examples such as these are frustrating to analysts and investors who embrace sustainable investing, they don't negate the value of investing this way.  Like other approaches to screening for attractive equity investments, the value of the approach is in emphasizing those at the top and avoiding those at the bottom.  Most investment firms in the ESG area use this "Best in Class" approach by investing in the best companies in each industry using ESG criteria, rather than avoiding entire industries because they might be major polluters, for example.


By favoring companies that rank high on ESG criteria and by avoiding the "bad actors" at the bottom, an investor can still achieve a portfolio that has lower risk and higher returns than by ignoring those factors or by investing in a market index.  For those who prefer to hire a professional money manager, they can employ a sustainable approach using individual stocks or mutual funds that are dedicated to a "sustainable" approach.


Steve Lehman
LehmanInvest.blogspot.com/