Environmental, Social and Governance factors (ESG) play an important role in how we select stocks, not only because these factors are important, but also because we believe management adherence to these principals can drive superior investment returns. We believe that the most impactful benefits of ESG come from not just investing in companies that post strong ESG scores, but perhaps even more so, from investing in companies that are making significant progress in improving ESG practices and outcomes. If investors ignore all but the companies that post perfect ESG scores they would deprive needed capital for businesses that have the determination and policies to improve their practices, and thus potentially lead to weak ESG improvement for society overall. If weaker, but improving ESG score companies are deprived of capital, they would likely lose competitiveness vs. companies in foreign and less regulated regions that take no regard of ESG in their corporate mission. Thus, in addition to evaluating the current ESG strengths of companies, we think investors should not disregard companies moving from good to great on ESG factors. Further, we believe improvement in ESG scores will likely driver higher financial returns for these companies over time, and improving ESG companies can be a compelling investment opportunity.
Governance, “G” describes strong, inclusive and strategic leadership. We believe the primary factor for success of any company is management’s ability to develop and execute a growth and return oriented strategic plan and to effectively manage superior capital allocation decisions. Cultural and gender diversity of management teams and board composition is necessary to see a wide view of potential threats and opportunities. Sensible and competitive compensation, board composition and employee development practices are not only important for ESG considerations, but in our opinion critical factors in the long-term competitiveness of any company.
Similarly, a company must pass a high social “S” factor hurdle to pass our investment process. Simply stated, we don’t believe a company can provide a sustainable, compelling investment opportunity if it alienates or denigrates its universe of employees, its customers, its suppliers or the communities in which it operates. Respect for diversity of religion, race, gender and sexual orientation of individuals anywhere in a company’s universe is a must to build a trusted business reputation and a leading brand. Also, involvement in both charitable endeavors and in minimizing harmful impacts of business operations in local communities (traffic congestion, worker safety, community development) all must be a focus of successful community relations. Common business sense is aligned with a positive social impact, as leading social practices are in our opinion critical factors for the long-term financial success of a company.
Perhaps the most visible impact of economic returns on ESG factors is seen in the Environmental, “E” factors. From a financial perspective, the direct impact of poor environmental practices can be devastating. The lost productivity, fines and costs of remediation for pollution, spills or other environmental damage create a significant cash outflow that not only impairs investor returns, but also weakens a company’s brands and reputation. Not only is it the right thing to do for companies to act as good direct stewards of the environment, but we think it is the most financially quantifiable factor of ESG investing.
While we are excited to see increased broad investor interest in ESG factors, we are concerned when we see rapid divestment of all companies in an environmentally challenged industry, without investor input to management teams or differentiation in ESG approaches. There are many industries that can potentially harm the environment but that are critical in meeting the basic needs of today’s society, such as oil and gas, plastics, steel, cement, and electronics manufacturing – even the manufacture of solar panels. Not only are U.S. companies in these sectors more regulated vs. global peers, they also can and should be held accountable for their environmental actions by investors through shareholder voting power and board member selection. If investors walk away from the U.S. public companies in these industries completely, the growing global demand for these products would likely be pushed from the U.S. to international jurisdictions where regulation and transparency of ESG efforts are greatly diminished.
Consistent with our view that investors should work with management teams to improve their ESG policies, we believe that the current, rapid divestment of oil and gas companies by some ESG focused investors, is misplaced. The IEA doesn’t expect a global oil demand peak until the mid-2030’s.* If all investors chose a cold-turkey exit of investment in U.S. exchange traded oil producers, we think production would rapidly move to more environmentally damaging locations, such as the developing world and off-shore, as global demand will be met from somewhere. We believe that investing in U.S. land-based oil companies that are improving their environmental practices is a much better alternative than complete divestment. We see several companies that are rapidly moving to capture vs. flare gas, recycle water, and move production by pipeline, as these are not only environmentally responsible practices, but can be higher financial return options for companies as well, due to avoidance of regulatory penalties and potentially higher revenues and lower costs. We also see compelling social benefits to retaining a U.S. presence in the oil sector as well, in benefits to U.S. economy, from U.S. job creation to the velocity of money kept in the U.S. by the purchase of domestic vs. imported oil.
In our view, a responsible ESG policy that allows for ownership of companies that are continually improving their environmental impact will not only drive greater overall ESG gains for society, but likely higher financial returns for investors.
* IEA (International Energy Agency) 2019 World Energy Outlook as reported by Bloomberg 11/12/2019.