Lawrence A. Cunningham’s Quality Investing: ESG investing can boost your stock market returns but it shouldn’t drive your portfolio


Can investing in stocks according to the U.N.’s ESG principles (environmental, social, governance) deliver value? Can such a strategy prove profitable according to investing principles promulgated by the likes of Ben Graham or Abby Joseph Cohen

The world’s largest asset managers seem to think so. A rising percentage of assets under management are allocated using this socially conscious approach and individual investors have joined the trend.

ESG investing is difficult to define and measure because the underlying principles are extremely vague. They talk of ecological awareness, general inclusion and “best practices” in corporate affairs. But there are few clear definitions, uniform standards or reliable benchmarks.   Many investors defer to third-party providers of rankings, such as the FTSE-Russell Index. Alas, the underlying scorecards are inconsistent and much of the  wisdom of these rankings is contested.

For some, ESG investing is an entirely new style of investing.  Rather than staking capital for the sake of economic gain, they redefine investing as staking capital for the sake of utility, including both economic and psychic advantage.  In this view, the very fact of siding with ESG principles immediately delivers investors value derived from virtuous action. 

While such utilitarian ESG investing is a rational approach, there are two problems. First, empirical evidence shows that the implicit boycott by such investors — withholding capital from ESG deviants — is not enough to induce desired corporate behavior changes. One academic paper concluded that rather than withhold investment, shareholders succeed in making such changes only by investing enough to seize control of the targeted corporation, akin to how activist shareholders recently seized seats on the board of ExxonMobil.  

The second problem with ESG investing is sociological. Research advocacy asserts that a lot of “social” impact investing aimed at helping targeted communities actually harms them. For instance, certain investments in affordable housing are damned as “profiting from our pain” when investors fund projects with little input from relevant community members. 

Is ESG worth the money?

But the question remains, is investing in ESG companies a prudent investment strategy? Can it outperform (add “alpha” in the context of asset managers edging out peer benchmarks? Alpha results when the investor correctly anticipates cost/benefits that the market underappreciated at the time of investment. With ESG, this means discerning how companies will benefit from — or be hurt by — governmental policies or developing innovative approaches to topics such as climate control, workforce diversity or corporate administration. 

This approach, however, reveals that perhaps there is nothing new or special about ESG investing that wasn’t captured by generations of investment theorists, such as Phil Fisher, Peter Lynch or Warren Buffett. That is to say, investment is inherently future looking and a successful analyst assesses the whole picture in projecting performance. ESG adds little to the toolkit, as intelligent investors have always benefited from a focus on sustainability, protecting constituents, and managerial integrity.    

Proponents might say that what’s different about ESG investing is it’s both intelligent investing and good for society.  While some contemporary economists suggest proponents cannot have it both ways — that you can’t both help society and your own portfolio — this is the age-old assertion of doing well by doing good.

In fact, it’s possible that the overall market is shifting from ESG indifference to ESG enthusiasm. The result: cash moving toward ESG companies raises their stock price, yielding short-term gains. (While such higher prices imply lower expected long-run returns, the process may take many years to complete.)  

The most cynical take on the vogue of ESG investing is that it yields neither positive social value nor alpha. Critics in this vein allege that ESG has been mostly marketing— and a dangerously deceptive campaign at that. ESG certainly has become a promotional tool for a diverse cohort of professionals, including information companieslaw firms, and consulting firms and it does require a broad skill set, encompassing climate scientists, sociologists, and experts in business and legal administration. 

But the traditional investor has always had to be a generalist, and ESG’s core principles correlate with some venerable aspirations, such as long-term sustainability, constituents in addition to shareholders, and proper stewardship.  In this view, ESG is old wine in new bottles — a new name for a venerable practice. 

For individual investors and asset managers alike, my advice is to incorporate ESG concepts into one’s general investment process, much as others have incorporated such perspectives as competitive advantage or corporate culture in evaluating a company.  Done well by focused long-term shareholders (quality shareholders), there is an excellent chance that the investor can do well by doing good.

Lawrence A. Cunningham is a professor at George Washington University, founder of the Quality Shareholders Group, and publisher, since 1997, of “The Essays of Warren Buffett: Lessons for Corporate America.”  For updates of Cunningham’s research about quality shareholders, sign up here

More: The ‘G’ in ESG is getting a big shake-up and it’s a win for stock investors

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