Business issues not traditionally included in the analysis of an investment portfolio are becoming more important value-producing elements for successful investing. This white paper explores how such convergence influences the manner in which we manage our ESG investment portfolios.
- For years, Environmental, Social and Governance (ESG) investing has offered investors the opportunity to help achieve their financial objectives in a way that is consistent with their beliefs and values.
- A growing body of evidence suggests that societal concerns about the workplace, environment and governance practices have become increasingly important business issues for many companies and industries.
- The ways that companies integrate these issues into their operations can potentially impact their competitive opportunities and growth potential.
Behind the Convergence
Previous white papers by our ESG Investment team have examined the factors driving the convergence of a company's business results with the ESG factors strategic to its operating arena. Among the factors driving this convergence are:
- Growing pressure to reduce greenhouse gas emissions and increase energy efficiency in operations and products.
- Globalization of the world's major economies and resulting changes in workforce demographics and customer and market populations.
- Increasing world population, growing prosperity and consumption among some segments of society, and the associated demand for goods and services.
- Expanding demands for goods and services on a limited natural resource base, and the resulting pressure to improve resource productivity.
- Better and more widely available information on the environmental and social impact of development on local communities and economies.
- Ever-increasing public and, consequently, governmental concerns about quality-of-life factors such as air and water quality, equity in the workplace, work-life balance, and human rights.
- The joining, or transfer, of behavioral attitudes developed by individuals in their daily lives as workers, parents, consumers, and community volunteers with their newly enlarged role as investors.
A New Framework
We believe these trends are reshaping the competitive landscape in many industries and are transforming seemingly non-financial, ESG issues from relatively minor factors in corporate decision-making into factors that are integral to competitiveness in the 21st century. It is our view that the companies likely to profit from these trends will be those whose leadership, values and corporate culture enable them to go beyond regulatory compliance and derive strategic value from their workplace, community and environmental initiatives.
We associate the degree to which companies acknowledge and respond to the ESG factors that emerge within their operating arena as indicative of their level of "awareness." Measuring this awareness is an imprecise exercise. Its analysis by asset managers is relatively new and still evolving. At ClearBridge, we frame our efforts around a "Best-in-Class"1 methodology, which aims to evaluate a company's capacity to manage the ESG drivers of business performance by analyzing corporate policies, management systems and practices, and a company's track record in these areas.
Some of the indicators we use in making this evaluation include:
- Workforce demographics and productivity, including recruitment and retention, training and development, work-life arrangements, occupational safety, employee and union relations, and global supply chain monitoring.
- Environmental indicators, including climatic, ecological and health impacts, strategic product advantages, innovation, and natural resource usage and "eco-efficiency".
- Community involvement, including engagement, transparency, stewardship (human rights, conservation, etc.), volunteerism, and strategic giving.
- Corporate governance, including management structure, board composition, governance guidelines, transparency and disclosure.
As one might expect, each sector of the economy (e.g., technology, energy, retail) is likely to face a different range of issues, given the different business environments in which they operate. Recognizing this, our sector analysts and portfolio managers selectively emphasize those particular issues that we believe are most relevant to a company's performance. For example, work force issues are generally critical success factors to technology and pharmaceutical companies because they operate in a creative environment, that is, their value depends on the innovation and intellect of their work force. On the other hand, issues of the environment and community may be of particular interest when evaluating natural resource companies because their business requires securing a license to operate and extract resources, through logging, drilling, etc.
The Value Creation Potential
It probably comes as no surprise that virtually every company will have some positive characteristics and some negative ones with regard to environmental, social and governance practices. We, as investment managers, must weigh the strengths against the challenges for each company and compare their performance with other companies in their sector to determine those that are on the leading edge and those that are lagging behind. These comparisons inform the internal ESG ratings our analysts assign to companies in their coverage universe. These determinations are made through our direct dialogue with management, proprietary sector analysis and third-party research, as well as publicly available information from industry and trade organizations, government agencies, public interest groups and other sources. New issues emerge from time to time and the importance of some issues may change as a result of legislation, shifts in consumer values and other socioeconomic conditions. Therefore, ESG integration is a continuous process.
We believe that an integrated approach to fundamental research, stock selection and portfolio construction enables us to identify top-quality corporate management teams that are better positioned to create strong, competitive advantages for their companies and stay on the leading edge of their industries. In turn, that selectivity can aid us in achieving our long-term portfolio goals of providing competitive, risk-adjusted returns. In addition, we believe an integrated approach to ESG investment provides an opportunity to interact with companies on these issues and equip leading-edge companies with the economic leverage to advance these issues across their entire value chain. Given our position as one of the largest shareholders in many of our portfolio companies, we believe the implications of sustainable investing could have significant, positive implications for the recognition of best practices in the market.