Wherever there are investors that are ready to put money into companies, you will also find analysts trying to figure out if that investment is a good idea. But what is a good investment? What is it that turns someone looking at a “good investment” that turns them into actual investors… individuals who are ready to put their money into a company? What gives an investor the confidence to fund a business?
First of all, investors wouldn’t be investors for very long if they didn’t get a return on their money. Most investors want to make at least the “average return”. That average always changes, but for the last century stocks have returned around 10% per year, and bonds have returned around 5%. Bonds are generally viewed as safer than stocks, and therefore have a lower return. Likewise, the more rock-solid and safe that a stock (or bond) is, the lower their return.
So far, so good. If you want to get a higher return, the trade-off is higher risk. Take on enough risk and the company you invested in may not make enough money to pay the return you expect, or it could even go out of business, costing you your entire investment. When investments pay more than what appear to be similar investments, there is usually more risk. But what makes an investment risky?
Unfortunately, there are no simple answers. Teams of research analysts work around the clock on every publicly traded corporation in America to answer this question, and they often arrive at dramatically different conclusions. And, of course, there are always dishonest corporations that hold back data or intentionally mislead investors.
The US and the UK put a lot of manpower and regulations into making risk information available and understandable. Few other nations have such high standards, and therefore are believed to have more hidden risk. That’s why the US and the UK attract so much foreign investment. Russia, Africa, and other less transparent nations lag behind. Wouldn’t it be great if there was some way, some universal and global way, to make it a bit less risky to invest?
Welcome to ESG: Environmental, Social and Governance. ESG won’t solve every problem nor will it de-risk every possible investment, but it does take a very big step towards creating a global standard (and cure?) for risk in investments.
While it is an over simplification, ESG basically promotes “good guy” thinking. When truly evil things are done in the world (polluting our environment, overcharging for critically needed medicine, abusing workers), we either find individual bad actors or we find that the corporation itself didn’t follow regulations and other rules. Corporations are regulated. They pay a ton of money for HR, Compliance and other internal groups that are supposed to sniff out bad people doing bad things.
Investment banks are regularly fined when they mislead investors. The Cigarette industry nearly collapsed due to their conspiracy to hide the dangers of their products. The asbestos industry DID collapse after their similar dishonesty was revealed. The drug companies that created the opioid crisis have just been fined $200 million. Oil and coal companies are being scrutinized. It does take a long time to discover endemic bad behavior, and when bad actors and bad corporations thrive, investors are often left with worthless investments.
If all corporations followed a universal set of ethics, risk would be easier to identify and track. It would be harder for bad players to hide. But corporations don’t want the world to know about their internal problems and shortcomings. Will they let the world know when they act selfishly or are just plain evil? They may not have a choice. Investors are better informed than in the past, and they are demanding to know how their investments are managed. Millenials are very clear that they want to invest in companies that support their personal interests and beliefs.
Even traditional investors are increasingly frustrated with the hidden risk in traditional corporations, and the idea that it’s only the “insiders” that can profit from big corporations. Investing in companies that support ESG has become very popular, and that interest is growing. In the US alone, ESG based assets totaled $8.7 trillion in 2016, a 33% increase from 2014. According to Oppenheimer, ESG based investments now represent 21.6% of all managed assets in the US, with a global total of $22.89 trillion.
WOW! ESG could define how capital markets work around the world. Lets look at the elements of ESG.
- Environmental: The corporate world has generally accepted that the environment… has value. Degrading the environment creates negative value. Improving the environment creates positive value. Financial analysts know that when corporations illegally dump toxic chemicals, they are eventually found out. Regulators, courts, and shareholders will hold them accountable. Analysts now measure environmental value, incentivizing pro-environmental activities.
- Social: Each corporation can make our world better or worse. A real estate developer that only builds luxury housing may be profitable, but generates little other value. A firm that builds housing for the poor, or hospitals, or schools… generates higher property values and new jobs… just like a luxury firm… but also does social good. Even when being a “good guy” only leads to a small positive value, it may be enough to sway some investors to the corporations that follow ESG.
- Governance: Elizabeth Holmes created Theranos, a $10 billion fraud. Their board of directors was impeccable, two former secretaries of state (Henry Kissinger, George Schultz), Wells Fargo’s former Chairman, and more. But not a trace of medical experience. The brilliance of the board was intended to blind financial analysts to it’s complete lack of appropriate expertise. While this was obviously intentional fraud, many boards of directors are 100% multi-millionaire white men, over 60, with an MBA from an ivy league school. Is this the BEST board to… identify opportunities in China and India, understand the consumer preferences of minorities, attract new Millennials, sell to women (50% of every market)? If you want to attract ESG investors, you had better carefully consider the ethnicity of your board!
Even the United Nations has taken an interest in ESG. ESG could bring about a more equitable world and encourage investments in the least developed nations. It would even allow the developed world to put a value the untouched resources of the undeveloped world, which just might help preserve some of those resources for another generation or two.
Nor is the UN alone. The PRI is a group that trains and certifies groups in the Six Principles of Investment, that the United Nations developed. If ESG is how to be a good guy, then PRI is the Bro’ Code, for good guys. And then you have the GRI (Global Reporting Initiative), which promotes “Sustainability Reporting”, a similar set of standards. Especially, for the Environmental and Social aspects of ESG.
It looks like ESG is breaking out all over the world! What about you? Do you have investments in a portfolio or a retirement fund? Have you ever thought about the values of your fund, and what your fund managers expect from the firms they invest in? Maybe you should give it a bit of thought, or even call the people who manage your money and see if ESG is on their mind!
What do you think? Should ESG matter? Is this just a fad, or does it represent values that you want to stick by? Let us know what you’re thinking!