By Marc J. Lane
Savvy individual and institutional investors are increasingly incorporating ESG (Environmental, Social and Governance) criteria into their investment decisions in order to enhance their risk-adjusted financial returns while backing only those companies that are doing the right things for the right reasons.
Environmental criteria may include how a company discloses and manages its risks around energy use, waste, pollution and energy usage. If a company owns contaminated land, disposes of hazardous waste or is responsible for toxic emissions, its compliance with regulatory requirements has both financial and reputational implications.
Social criteria will almost always include a company’s diversity, equity and inclusion policies and practices, as they affect employees and suppliers. How well a company provides for its employees’ financial security, opportunities for advancement, health and safety will impact the talent pool from which it can reasonably be expected to draw. And a company’s customers will take notice of its involvement in the communities in which it operates.
Good governance demands that a company’s stockholders, lenders and other stakeholders can count on transparency and accountability, reasonable executive compensation tied to performance, and the right of all stockholders to vote on every important corporate decision. Beyond that, the well-governed company will robustly guard against director and officer conflicts of interest and corrupt practices.
Based on the empirical findings my book Profitable Socially Responsible Investing (Institutional Investor: London) reports, I strongly advocate screening for ESG considerations as part of the investment selection process. Not only can ESG help mitigate financial risks and optimize financial rewards; it can also ensure that one’s investments are aligned with the investor’s core values or missions.
The case for sustainable investing has understandably caught fire. Global ESG assets are on pace to exceed $53 trillion, representing more than one-third of total assets under management worldwide, by 2025.
But it’s time to look beyond the company.
As effective as ESG can be, it doesn’t, on its own, successfully take into account the impact a company’s behavior may have on the critical systems that undergird our economy or, for that reason, the other holdings in an investor’s diversified portfolio. That’s why, when evaluating a possible investment target or considering how to vote on a corporate resolution, the prudent investor should never ignore a company’s “externalities,” its effects on third parties.
Some externalities are negative. For example, when Pfizer and Johnson & Johnson, both generally seen as virtuous corporate citizens, resist calls to waive the World Trade Organization’s intellectual property rules for their vaccine technologies, they increase their profit margins at the expense of global public health and lower global GDP. Or when Tractor Supply Company, the largest rural lifestyle retailer in the United States and a good steward of the land and natural resources, fails to pay its employees a living wage, the company may suffer the consequences. But the company’s compensation strategy also penalizes the rest of us who aren’t immune to the broader financial and social costs of its decision.
While such negative externalities burden all of us in obvious and subtle ways, positive externalities present opportunities for investors to leverage their capital for both their own benefit and the common good. Take fintech startups whose disruption threat has forced local commercial banks in Africa and other emerging markets to serve micro and small businesses, tapping into their own deep pockets and lower capital costs to improve the lives of the poor.
Let’s require companies to publicly disclose the financial and social costs of their externalities, good and bad. The market will fairly reward those companies whose externalities are positive and punish those whose externalities are negative. We’ll all be better off when a “race to the top” encourages investors to buy into a better future.
If you would like to explore how Marc J. Lane & Company, our investment affiliate, can help you develop a more responsible and sustainable investment portfolio, please reach out to Marc Lane in confidence. He can be reached at 312/372-1040 or mlane@MarcJLane.com.