Factors Beyond the Fundamentals

Factors Beyond the Fundamentals

In recent weeks there have been calls by Ukrainian officials for companies to take a stand against the Russian invasion, and many companies have responded beyond the government sanctions. This is not the first time that companies have taken a stand on political issues. Some companies make a point to embrace social issues as well, while others try to stay on the sidelines. The question of whether or not a company will be more profitable if it is also moral is still up for debate, and whether or not an investor should take factors into consideration beyond the companies’ financial fundamentals is becoming a larger concern.

Investors looking at the social impact of business might be traced back to the 1700s. Quakers forbade their members to participate in the slave trade. John Wesley, one of the founders of Methodism, advised avoiding investing in companies that injured employee health. Although some of these issues have been resolved through the law, there are still companies that may engage in activities many are repulsed by. In the 1990s this idea of avoiding “bad” companies took shape as socially responsible investing, when one avoided buying companies for their portfolio that engaged in “sin” or “vice”. The first companies on the chopping block were tobacco companies, casinos, and gun manufacturers, but many others could be screened out as well, such as oil companies or liquor manufacturers. Although screening out disfavored firms may have made investors feel virtuous, it didn’t affect the fortunes of those firms in a material way. In fact, the “vice stocks” generally outperformed the market as a whole, because those companies tended to be rather profitable, paying generous dividends to their shareholders.

However, data management in recent years has made it possible to do more than just look at the industry a company is in, or the product it manufactures. We can now screen for many factors, positive as well as negative, that might help guide our decision to own a slice of these companies. This new approach is called environmental, social, and governance (ESG) investing, and the idea is that factors from those three categories may help (or hinder) a company’s ability to grow. Although it may seem as those “sin” factors can outperform, so can “virtues”. Virtues may outgrow other companies because more investors are interested in feeling good about what they own, or because they represent the future, or because they represent good business practices. As a notable example, Ford paid its employees more, the wages were equal regardless of race, with more vacation and sick days, and without a union forcing him to do these things. At the time, some may have thought this to be poor governance since it didn’t promote the bottom line as hard as it could have, but others may have realized the hidden benefits, as it would lead to less employee turnover and happier and more productive employees. This type of governance might lead to long-term success.

Some have argued that companies with higher ESG scores are less likely to be disrupted by environmental problems, labor relations woes, or governance scandals, and as such may provide superior risk-adjusted returns. It is too soon to answer that question with complete confidence, but ESG factors are worth considering beyond only their moral implication. Here are factors found in each category:

Concerns about the environment include:

  • Climate change policies, plans, and disclosures.
  • Greenhouse gas emissions goals.
  • Carbon footprint and carbon intensity.
  • Water-related issues and goals, such as usage, conservation, overfishing, and waste disposal.
  • Green products, technologies, and infrastructure.

Social concerns may include:

  • Employee treatment, pay, benefits, and perks.
  • Employee safety policies including sexual harassment prevention.
  • Diversity and inclusion in hiring and in awarding advancement opportunities and raises.
  • Ethical supply chain sourcing, such as conflict-free minerals and responsibly sourced food and coffee.
  • Public stance on social justice issues, as well as lobbying efforts.

Governance covers such areas as:

  • Whether executives are entitled to golden parachutes (huge bonuses upon exit).
  • Diversity of the board of directors and management team.
  • Whether chairman and CEO roles are separate.
  • Dual- or multiple-class stock structures.
  • Transparency in communicating with shareholders, and history of lawsuits brought by shareholders.

These new ESG factors have already started making an impact in how investors choose companies, as well as how some Exchange Traded Funds (ETFs) and Mutual Funds choose companies, and that impact is likely to grow. Companies may be scored for their ESG performance. They may self-report, or data may be gathered by third parties who then sell the data. These scores may be combined with traditional financial analysis tools in determining which companies are likely to have the desired impact while still providing strong returns to shareholders. One difficulty is that the scoring is not necessarily universal and easy to understand yet, and some companies may score extremely well in certain categories while doing poorly in others, providing a relatively high ESG score, though it might fail in the category that doesn’t align with your goals and sensibilities. While there may not be an ESG factor for a companies’ stance on Ukraine, it might affect how much consumers want to support them and their products and how much investors want to own them too.

At Garden State Trust company, we help clients make a difference in many ways, from optimizing charitable gifts to creating special needs trusts. We also build each portfolio for each client according to their unique needs and situation, utilizing their appetite for risk and time horizon to help them meet their goals. If you wish to discuss how your investment goals can be accomplished while also taking ESG factors into account, please let us know. We’d be pleased to share our expertise and experience.