“Good leadership requires you to surround yourself with people of diverse perspectives who can disagree with you without fear of retaliation.”
-Doris Kearns Goodwin, Biographer, Historian and Author of
Team of Rivals: the Political Genius of Abraham Lincoln
As the markets have continued to recover from the February sell-offs (probably too much, too fast in my opinion) we’re starting to see how various different assets and asset classes held up over this unique time period. Now of course, certain individual industries performed exceedingly well or exceedingly poorly based on this particular circumstance. Companies that make paper goods, cleaning products and allow for online meetings had a big boost while airlines, restaurant chains and hotels have all suffered. But that’s not an “investment model” that can be duplicated. Assuming things continue to improve with the Cornoavirus and we get a vaccine sometime early next year, the trigger for the next stock market correction will likely be something completely different. Shifting your investments to toilet paper and away from tap rooms shouldn’t have any lasting impact. What I’m talking about are investments that performed above expectations with less specificity, the kind of investments you might be able to build a portfolio around.
Last month I briefly mentioned how ESG investments, those that stress the Environmental, Social and Governance of the companies they invest in, have seemed to hold up very well during this crisis. I wanted to expand on that in this newsletter and explain why you need to start paying attention to the S&G of these investments and stop thinking about them as simply something for the eco-warriors. Favoring companies who have better environmental records fits in with the world view of more and more people, but there can be an argument that it also brings higher operating costs for those companies. The cost of alternative energy and sustainable building products has dropped substantially over the years, but they still, on average, cost more. If a company is going to build its new headquarters with bamboo floors rather than laminate, we look at that as an extra expense on the bottom line. I could spend the next two thousand words discussing sustainability and the long-term savings of solar over carbon-based products, but suffice it to say some environmentally friendly policies still cost more to implement than “traditional” energy, materials, packaging, building etc. Not to mention that you could be avoiding whole areas of the economy. That’s why we’re going to leave the E alone and talk about S&G.
S stands for Social. This is the way a company interacts with its employees and the community around it. In the cult classic movie,
Office Space, protagonist Peter has an interview with corporate consultants and sums up the disfunction in far too many large companies with this quote, “That’s my only real motivation is not to be hassled, that and the fear of losing my job. But you know, Bob, that will only make someone work just hard enough not to get fired.” The “S” in ESG strives to select companies that don’t have this type of workforce. There are certainly feel good components to this category; companies that avoid child labor may not be saving themselves any money but I think we can all agree that’s a good idea. But it also stresses companies that have better family leave policies, closer to equal pay for male and female employees, extend benefits to same-sex partners in regions where those relationships are not written into law, offer proper breaks, sick and vacation time, bonuses and work incentives, maybe stock options. Basically, it favors companies that treat their employees better than average. These offerings may seem like they cost more, but evidence shows that this cost is more than made up in having a better, happier workforce. The best talent would prefer to work for a company with these benefits, meaning you get smarter and harder working employees; not to mention being less likely to find yourself involved in strikes or lawsuits. If the local schools, hospitals and recreational facilities are also better, thanks to donations of money or time from the companies located in a particular area, it makes it that much easier for them to recruit the best talent. Then when the going gets tough, let’s say there’s a pandemic for an outlandish example, those same employees are more likely to voluntarily take furlough days, or reduced pay and yet keep working hard for their employer.
When I was doing my first studying for the CFP® I had to read an extremely exciting book titled, “Fundamentals of Investments for Financial Planning.” Not exactly a beach read, but it did introduce me to a classic problem in publicly traded companies that has only gotten worse over the twenty years since I slogged through that textbook. It’s called
The Agency Problem and it occurs when the management of a company run the company more for their benefit than the benefit of the shareholders. In our world today a huge percentage of investment dollars are in index investments. These investments each own small pieces of companies in order to match the underlying index they’re trying to track. While the investment companies are technically the owners of the corporations whose stock they hold, in many cases they don’t pay that much attention to who is on the Board of Directors or what they are being asked to vote on. Therefore, what the management wants they tend to get. While this has always been a problem it has been exacerbated as these passive investments own a larger percentage of these corporations and (with exceptions of course) often rubber stamp the recommendations of the executives. We see this most notably when a company goes through a scandal or huge drop in value and the CEO walks away with tens of millions of dollars in some kind of severance package. The G in ESG tries to solve this problem. Not only do investments in the ESG space try to tilt toward companies that have more balance between executive and worker pay, and away from those with golden parachutes for their top employees – but more importantly they are often mandated to vote against these provisions in the first place. The best way to hold a company accountable is having a truly independent board of directors, but if the CEO is picking the board and the passive owners are going along with it, you end up with a board, to quote character Jack Donaghy from the show
30 Rock, made up of “golf cronies, hunting buddies, unemployable family members and his hunting dogs.” In ESG investments, the investment company owners use their voting ability to make sure that doesn’t happen and the board is a truly independent voice for the shareholders. This should lead to companies where they management can’t loot the place for their own inflated salaries and this in turn should lead to companies that return more of what they earn to the shareholders. The added bonus of having an accountable executive suite is a lesser likelihood of scandals that lead to negative press and in some cases boycotts of your products.
Based on all this you should, by invoking an ESG screen on your investments, end up with higher quality companies with more productive employees and executives who are working for the shareholder rather than themselves. What’s more, many ESG investments not only require the initial screening of corporations before they buy them, but after they own them they are mandated to vote at shareholder meetings or through proxies, for policies and board members who will continue to improve the Environmental, Social and Governance. This is often called “impact” investing and it’s what truly differentiates the old “Socially Conscientious” investing from what we now call ESG. We believe these underlying companies should perform better than their peers based on the comparable indices' performance so far this year. Through May 31 the MSCI USA ESG Select Index returned -2.23% year to date but was a positive 17.30% over one full year. The MSCI’s regular U.S. Stock Market Index (MSCI USA Large Cap) returned -4.00% year to date and 14.07% over a full year. (All data can be found at MSCI.com) If you stretch that index back further it continues to show equal or better returns and lower risk over almost every time period. There are many other ESG indexes, from the S&P ESG to the U.S. STOXX ESG Impact index. While they all slightly differ in time periods and exact definitions of ESG we are finding trends of limited sacrifice of return if not higher returns and lower overall risk, especially as of late. This is no guarantee and the time periods of these indexes are far shorter than the overall market that we can track back to 1923.
I encourage all of you to take a closer look at ESG, even if the Environmental part of the category isn’t particularly important to you. I know it’s not hard science, but just think to your own work experiences. Think of the good vs. bad work environments you may have been in over the years. Didn’t the better work environments include smarter, harder working employees and better results? It can’t be a coincidence that the “Best Places to Work” lists that come out annually correspond so well with the fastest growing companies.
MSCI USA ESG Select Index is designed to target companies with positive environmental, social and governance (ESG) factors while exhibiting the risk and return characteristics similar to those of the MSCI USA Index.
The MACI USA Large Cap Index is designed to measure the performance of the large cap segment of the U.S. Market.
Any investment's socially responsible focuse may limit the investment options available to the investment and may result in returns lower than those from investments not subject to such investment considerations.