If your mouth is saying we need to care more about our planet, make sure businesses are treating their workers with dignity and are running by high governance standards, then responsible investing is a way of putting your money where your mouth is.
Responsible investing incorporates Environmental, Social and Governance (ESG) factors into decision making, which are wide-ranging and cover things like:
- How companies respond to climate change;
- How appropriately they manage water supplies;
- How they implement safety policies;
- How they manage supply chains; and,
- Their commitment to transparency and diversity.
ESG investors recognise that information about a company’s environmental, social and governance conduct is vital to understanding the business purpose, strategy and management.
Fortunately, this shift in mentality doesn’t have to come at the expense of value.
Businesses that grind out profits, caring little for their impact on the earth or how they treat their workers, are found to often underperform the businesses that do care.
Maximising profits is the name of any investing game, but as technology evolves and investors pressure businesses to improve their conduct, economic efficiencies spring up and new revenue streams appear.
The idea that investors who integrate corporate environmental, social and governance factors into investment decisions can better manage risk and improve returns is now rapidly spreading across capital markets all over the world.
Economics is remarkable like that.
How do you screen for it?
Each investor has their own way of approaching ESG factors.
And a lot of it comes down to the values of the investor and those whose money they are managing.
Rather than Socially Responsible Investing, which is an older ethical framework, ESG investing considers factors that are financially relevant.
Once you’ve decided on the factors important to you, you apply screens to individual businesses.
Negative screens
Screening companies is a way of filtering shares based on user-defined metrics.
In the case of ESG investing, Negative Screening focuses on excluding certain types of companies.
If you decide producers of tobacco or nuclear weapons, those with questionable supply chains, opaque human rights policies or those who have no waste disposal policies for example, don’t deserve your money, then you deliberately avoid putting them in your portfolio.
Negative screens are a useful starting point to help a fund decide what their values and priorities actually are .
Once the screen has been established, it helps a fund identify companies that do not meet its ESG criteria.
Traditional ESG-managed funds and exchange-traded funds (ETFs) typically only use negative screening, filtering out the businesses that don’t align with their values.
Positive screens
Positive Screening is generally focused on including companies with strong environmental, social and governance characteristics.
It is usually used alongside negative screening.
You can do it a few ways:
- Companies that sell positive products – like educational material or essential necessities of life (food, clothing, electricity, water or housing);
- Thematic investing – investing in specific areas such as environmental technology;
- Best-in-class – favouring companies with best practice relative to every other company in a sector.
An example of an ESG investing process
Step one: Qualitative analysis
This is where you use your subjective analysis to have a look at things like:
The economy in a country:
- Is that nation abiding by international human rights charters and governing in the best interests of the people?
- Is the economy running openly and sustainably, without corrupt intervention or cartel-like business?
How the industry performs:
- Is the industry you’re looking at likely to contribute to global sustainability? Is it progressive and evolving?
Company strategy:
- Does the company strategy align with your values?
- Is that strategy transparent?
Quality of management:
- Are those running the company committed to transparency and ESG-related values?
- Are they just about maximising profit at any cost?
Step two: Quantitative analysis
This is where you break out the numbers and look at:
Financial forecasting:
- Can you identify future revenue and expenditure trends?
Models:
- Looking at the business assumption and drivers, income statements, balance sheets, cash flow statements and other valuations, determine whether the business is likely to make money in the future!
Step 3: Decide if you want to invest
- Buy shares? Or increase your weighting?
- Hold?
- Sell shares? Or decrease your weighting?
- Don’t invest at all.
Active ownership assessment
Company engagement
- Go and meet the company! Ask them questions about their strategy, discover what their values are (and how they define certain criteria).
Voting
- Ensure you have voting rights so when Annual General Meetings roll around and shareholders are asked to vote on issues, you have a say. This is one of the most powerful ways shareholders can influence the running of companies.
Conclusion
Rather than a hard and fast set of inflexible criteria, ESG investing involves a careful study of your own values and a series of decisions that reflect that.
The explosion of ESG investing around the world is a powerful step towards considerate capital allocation.
