What is ESG? A Quick Tutorial on Sustainable Investing

What is ESG? A Quick Tutorial on Sustainable Investing

Aside from “fiduciary,” the financial industry’s buzzword of the moment is “ESG investing.” I’ve seen TV ads, read newspaper articles, and listened to interviews with ESG investors. But what is ESG? Earning Super Growth? Endive Salad Greens? 

ESG stands for “environmental, social, governance,” the three key tenants of sustainable investing. The terms “ESG” and “sustainable investing” are often used interchangeably, but the best I can gather, “ESG” represents the criteria while “sustainable investing” represents the implementation. 

I’ve had conversations recently with a few clients on the subject of sustainable investing, and the idea seems to really stick with people as they learn more about it. Why wouldn’t it stick? Sustainable investing is all about doing the right thing, or at least investing in companies that make doing the right thing a priority. On the contrary, are there investors out there that say, “I want to exclusively own stock in companies that ruin the environment, lie to their shareholders, and treat employees like prisoners”? I hope not… but… probably.

So how does it work? There are a couple of ways investment managers go about selecting funds for their ESG portfolios:

At first, ESG investors used an exclusionary approach. They would create a set of criteria and then screen out any company involved in the sale, promotion, or manufacturing of those criteria elements. Guns/ammunition, cigarettes, casinos, and chemicals are popular screens, as are cosmetics (unfriendly to animals) and oil & gas companies. To those familiar with the idea of “sin stocks,” this should sound very similar. The benefit of this method is that it’s very cut-and-dry. You’re either in or you’re out. But that same benefit is also perhaps the greatest drawback. No company can be perfect. Sustainable, solar-powered hippie communes don’t go public very often. Making this analysis too black-and-white may severely limit the opportunity set of available investments.

As time has gone on and technology has allowed evaluation methods to be more complex, many ESG investors will now use what Raymond James calls “integration.” This method combines traditional fundamental analysis (things like cash flows, profitability, market share, etc.) with ESG metrics like EPA regulatory violations, worker pay, shareholder voting opportunities, et cetera. Instead of flat-out eliminating companies because they’re involved in something objectionable, the integration method scores and ranks companies based on those criteria. It’s a balancing act between financial success and social commitment, allowing for quite a bit of customization to decide which particular metrics receive the greatest weights and are most important to a given portfolio manager’s investors.

As people around the world become more conscious of their impact on their fellow man and on their planet, I think the ESG investment opportunity set will only grow. In fact, many of the largest ESG-friendly companies today are also the largest companies in the S&P 500 (think Amazon, Apple, Microsoft…), signaling that executives already know their employees, customers, and shareholders care about these things.

For those who are interested in learning more, please reach out. Also, here’s a link to JUST Capital, a 501(c)3 founded by several major investors and public figures with the goal of making the ESG investment process a little more transparent. https://justcapital.com/

Benjamin Sadtler, CFA

The above article is for informational and educational purposes only. Neither the information presented nor any opinion expressed constitutes a recommendation or endorsement by Gore Capital Management nor Cantella & Co., Inc. of a specific investment or the purchase or sale of any securities.

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