Who decides what is good?
In equity research, we focus on the risks that could arise from ESG factors. Generally, we find that these risks may not currently affect a company but have meaningful potential to. Building on this, we’d think of sustainable investing as appropriately taking into account ESG risks when making investment decisions.
On the other hand, socially responsible investing, or SRI, considers personal preferences, avoiding industries that might not agree with one’s values.
Values-based investing is ultimately up to the investor. We’re more focused on the valuation impact. However, we think the broader investor community would be remiss to ignore values completely. While an individual investor might not hold a particular value, they should be aware that some ESG risks can manifest from the values of a larger group. In other words, values among other stakeholders could lead to an economic impact, and thus affect equity holders through a lower stock valuation.
Why should investors care about their ESG risk?
ESG should matter to investors because it identifies potential risks that could affect a stock price. Just like investors would want to know if a company could run into trouble from having too much debt, or selling products in a declining industry, it is important for investors to consider ESG risks that could hurt a stock.
For example, chemicals companies face risks from environmental damage that can ultimately cost billions of dollars to clean up, such as asbestos lawsuits that left many companies bankrupt. Similarly, beverage companies must continually monitor their water use as they may have to pay higher costs or even stop producing beverages if they use too much water. Any company whose employees are unionized is at risk that their employees will go on strike due to poor working conditions. All of these are ESG risks that could hurt investors.
How does one take an equity research approach toward ESG?
Morningstar’s equity research approach focuses on valuation and long-term orientation. Our approach for ESG is about understanding and capturing these risks in our stock recommendations. To do this, we integrate ESG factors in our intrinsic value estimate (through our fair value estimate and economic moat rating), as well as our required margin of safety (through our uncertainty rating). By identifying and assessing these risks, we can use ESG analysis to better understand company risks and incorporate that into our stock calls today.
When analysing a stock how does one differentiate between risk and impact?
Early this year, Terry Smith, founder of British investment firm Fundsmith, expressed his frustrations as a top-10 shareholder of Unilever, whose performance lagged peers severely in 2021. "Unilever seems to be laboring under the weight of a management that is obsessed with publicly displaying sustainability credentials at the expense of focusing on the fundamentals of the business," Smith wrote his clients.
Unilever has a long history of focusing heavily on sustainability. It adopted the Unilever Sustainable Living Plan in 2010 under previous CEO Paul Polman. Under current CEO Alan Jope, it's pursuing the Unilever Compass strategy that focuses on using its brands as a "force for good."
Unfortunately, that focus hasn't turned into return. Unilever's stock has underperformed peer Procter & Gamble and the Morningstar Global Markets Index over the past five years. Admittedly, P&G's stock price benefited from a successful restructuring. Still, the market hasn't given any kind of premium to Unilever for its sustainability credentials.
It's critical to make a distinction between risk and impact when considering the ESG factors used in sustainable investing.
ESG risk, or risks related to things like climate change impact, or worker safety, is like any other business risk. Its effect on valuation and thus, on return, is clear, which necessitates management prioritization.
Impact is about improving ESG issues for society's benefit. Often, it's based on values (rather than valuation), and centered on nonfinancial outcomes. While it may be important to individual investors, a company's actions here may or may not improve the bottom line. And most challenging, impact measurement is complicated and difficult.
Risk is relatively easier to understand and measure. It can be quantified and reported. We can incorporate ESG risk (and its inverse, opportunity) into our valuations, and investors can estimate how ESG risk affects a company's worth. We can also consider multiple risks to estimate ESG risk impact in totality.
In contrast, it's incredibly difficult to estimate if a company's impact pursuits are making a difference on a global basis. While there are plenty of metrics to assess ESG risk, there are fewer for impact. Thus, it's challenging to objectively measure whether a company's spending to drive this impact is "worth it," as the answer will depend heavily on each investor's preferences and perception. And the lack of detailed disclosures on how much is actually spent toward these goals adds even more difficulty.
Despite the confusion, the incorporation of impact goals into management priorities has become increasingly common, perhaps nowhere as much as in the consumer sector. This makes some sense, as customers are arguably incorporating values into purchase decisions more than ever. Indeed, Coca-Cola, Mondelez, and General Mills all had ESG investor days last year highlighting their sustainability goals. Mondelez has gone as far as to incorporate ESG goals into its nonfinancial key performance indicators for determining management compensation.
For now, it's unclear how beneficial such moves are for investors, the company, or the world. We hesitate any time we see executive compensation tied to something that's not as objectively measured or well-understood as financial metrics are. Maybe we're being too cynical, but the risk that management or a company's board could adjust, massage, or otherwise "game" the goals and their payouts gives us pause. After all, executive compensation growth has outpaced both financial and share price performance, for the most part.
Second, impact is tied to values, and investors have different values and issues they care about. Without an infinite checkbook, someone will be left disappointed. As just one example, one investor may prioritize reducing plastic waste, while another may prioritize reducing carbon emissions. Because plastic offers a lower-carbon alternative to many other packaging options, following the former's preference risks failing the latter's. It's not clear whether management teams, or even corporations themselves, are best placed to make (yet alone be measured on) these trade-offs.
Lastly, it's important to understand the relationship between impact and returns. As with any investment, not every dollar spent toward impact issues is going to result in stellar financial returns. And many impact investments are unlikely to create moats in themselves. For example, reducing carbon emissions does not inherently carve durable competitive advantages given that it's a replicable activity. Thus, it's highly possible that the spending could weigh on stock price performance, as Smith seems to claim with Unilever.
What must investors do?
As always, we advocate for a clear delineation of price versus value in making investment decisions--across both the risk and impact spectrums. It seems likely that market participants will sometimes misprice the risk facing a company from ESG factors, or underestimate the societal impact that firms can drive and potential economic value that may accrue as a result. But we would be surprised if those factors were being consistently overlooked and underappreciated; a generally efficient market should close the door on any such structural opportunity pretty quickly.
For prudent investors, the path forward is the same we've walked for some time--a focus on the contributions or detractions from risks and opportunities that can affect a company's worth--but with the additional lens that increased ESG data provides.
More on ESG
The above has been taken from Why ESG investing is about more than feeling good and ESG Risk Management Makes Sense, but ESG Impact Is Less Straightforward