End of Week Notes
Avoiding “irresponsible” companies vs. investing in “sustainable” ones
We had a great turnout for our first Morningstar Sustainable Investing Quarterly Webinar this week. Calvert Research & Management CEO John Streur, my colleague Gabriel Presler, and I discussed the sustainable funds landscape in the U.S., high levels of investor interest in sustainability and how to translate that interest into invested assets.
But there were questions. Many questions. I’ll be answering them over the next week or two on the Morningstar blog, but here I take a stab at this one:
How does my ownership or avoidance of an “irresponsible” company make a difference? Wouldn’t those shares just be owned by a different investor?
This question is an example of why language makes a difference. Even though the terms “responsible” and “sustainable” investing are often used interchangeably today, the use of “irresponsible” here obscures the main thrust of what I prefer to call “sustainable investing.”
Most sustainable funds today are focused on integrating the consideration of environmental, social, and corporate governance (ESG) issues in the investment process. The idea is to populate a portfolio with companies that perform well on the financially material ESG-related issues that affect their businesses and avoid those that are not addressing these issues effectively.
For a transportation company — an airline, for example — the biggest ESG concerns may be carbon emissions, safety, and human capital. For a social-media company, major ESG issues include data privacy and security, content governance, and anti-competitive practices.
All other things equal, an ESG manager prefers the ESG leaders over the laggards. In so doing, the portfolio has less exposure to ESG-related risks. Companies that address ESG risks most effectively also tend to be high-quality companies. In fact, my view is that strong ESG performance is becoming a hallmark of what it means to be a quality company in the 21st Century. Quality companies tend to turn their competitive advantages into steady long-term growth. The point is not to identify “responsible=good” and “irresponsible=bad” companies. The point is to identify companies that are more effectively addressing the significant ESG issues they face today. It is not so much about reflecting an investor’s values as it is about enhancing the value of the portfolio.
All that said, the question does have relevance when it comes to excluding a company from a portfolio based on its primary activities: a tobacco company, for example, or one heavily exposed to fossil fuels. Does avoidance make a difference? Wouldn’t another investor come along to take the place of the “responsible” investor? And if enough investors shun a company’s stock, it could become undervalued and end up outperforming for those who don’t have any problem investing in it.
There are three ways that avoidance or divestment can make a difference:
- By sending a broader message about the harmful effects of a company or its products, avoidance can help drive social change. And companies are more concerned than ever before about their reputation.
- Avoidance/divestment can be a substantive, financially-driven investment view. Avoiding companies exposed to fossil fuel, for example, may reflect the view that fossil-fuel reserves are doomed to become stranded assets and those companies whose business is fossil-fuel extraction will underperform and eventually go out of business.
- From a behavioral-finance perspective, like any other product/service that I buy, in addition to the utilitarian benefit I get from an investment (an increase in wealth), I receive emotional (how does it make me feel?) and expressive (does it reflect who I am?) benefits. If I think that investing in guns or tobacco or private prisons is immoral, then I want them out of my portfolio because my emotional and expressive payouts are negative. It’s just not worth it to me. I can make money other ways.
And especially now that we know so much more about allocation and diversification, it’s generally easy to substitute for exclusions so that overall performance isn’t affected, as noted by Blitz and Fabozzi (2017). And even if performance is affected, my behavioral efficient frontier, which takes into account the negative emotional and expressive benefits I receive, is lower than my purely financial mean-variance frontier, so I accept the tradeoff. It may not make a difference to the market, but it makes a difference to me. For more on this point, see Meir Statman’s book, Finance for Normal People.
Weekend Reads
Check out the CDP’s new report estimating the financial costs of climate change. The total financial impact could be nearly $1 trillion. But wait! That’s based on only 215 companies that disclosed their potential costs, so the implication is that the climate crisis will cost public companies trillions. On the other hand, some industries will profit from climate opportunities. Here is the link to the report, or check out the summary in Fast Company:
Climate risk is no longer a niche issue that only affects certain industries:
I agree with Robert Gibbins that the impacts of climate change are happening suddenly — as in, right now — much sooner than we thought even a year or two ago. Gibbins thinks the (post-Trump) U.S. and Europe will take the global lead to limit carbon emissions. Big oil and oil-dependent nations are vulnerable.
Two more Democratic candidates released their climate plans this week.
Happy reading.
