ESG Can Improve Corporate and Investment Performance

There’s long been a debate about the role of business in society, which I’ll address in a later post. For now, let’s stick with related question of whether it pays for an investor to focus on ESG. There’s a growing body of rigorous, quantitative evidence that it does (e.g., Harvard study, Barclays reportStanford working paper), but in this post I’ll focus on a viewpoint that is less well represented, that of a practitioner’s view.

At Inherent Group, we use environmental, social, and governance (ESG) factors to source, underwrite, and engage with companies. We use these factors in conjunction with a traditional investment process and risk-management framework developed over our careers at leading investment organizations. We think this makes us better investors. We think of it as value investing with an edge.

Sourcing:  Investing behind the themes of electrification of transportation and grid modernization is good for the planet as we shift away from more polluting energy sources, but also benefits from a large and sustained economic tailwind as the cost of power declines and as the markets for electric power expand. It’s not enough, of course, for an investment target to provide a valuable service with a growing TAM, but it’s a good place to start in identifying opportunities. The best potential investments should also be cheap – relative to their cost of capital and to the broader set of investment opportunities.

Underwriting:  Analyst to CFO: “Can you help me bridge 2017 to 2018 EBITDA?”  CFO to him- or herself: hit repeat on the same shpiel given to every other investor. Analyst to CFO: “Tell us about how you balance the pressure to generate short-term returns with the need to create long-term value for the company.” This requires a thoughtful response. We have a series of culture and ESG questions that we ask in addition to specific financial and strategic questions. We find that asking all of these questions, and of many different people throughout a company, provides a broader picture of a company’s DNA. How do they think about risk management, developing their people, long-term compounding of capital, operational excellence, innovation, etc.?

Engagement:  We believe that companies that lead on material ESG issues will trade at higher multiples than they would otherwise and we engage with companies to improve their ESG performance.  A natural gas pipeline company that is an industry leader in curbing methane gas emissions has a stream of cashflows that should be less risky, and therefore more valuable, than its competitors’ cashflows, all else equal. And the company should benefit from a lower cost of capital in the form of tighter credit spreads and higher equity multiples.

If we and other investors can demonstrate this last point, then we can show companies that it is in their enlightened self-interest to lead on the material ESG issues relevant to their business. That will be a good day – for business, for investors, for society, and for the planet.