Until a decade ago, most diligence processes conducted while creating investment theses were built on mostly financial analysis — an arbitrage between risk 🚫(debt, slowing growth, employee turnover, competitive pressures…) and reward ✅ (Company being Acquired, IPO, new market entrance, new product launch…). But that’s not the case anymore. As companies’ financial performance increasingly correlates with good management of extra-financial risks, investment professionals, are challenged to rethink the ways in which they evaluate a company and decide whether to invest.
A recent measure of performance that has been getting attention is Impact as an extra-financial element. Value-based investing, as a result of this, is an investment approach that looks at the environmental and social impact of a company’s actions, products, and leaders. While there is still isn’t a standard methodology around measuring this non-financial “value” or “impact”, the three most common approaches are — Impact Investing, Socially Responsible (SRI), and Environmental, Social & Governance (ESG).
In 2020, ESG-oriented investing accounted for $40.5 trillion in investments and is on track to exceed $53 trillion by 2025 (more than a third of the $140.5 trillion in projected total assets under management). The success of such ESG-focused investment approaches is often linked to cash flows in five important ways -
- facilitating top-line growth
- reducing costs
- minimizing regulatory and legal intervention
- increasing employee productivity, and
- optimizing investment and capital expenditures
In 2020, the performance of Impact-oriented portfolios overwhelmingly met, even exceeded investor expectations for both impact and financial return, in investments spanning emerging markets, developed markets, and the market as a whole.
But, what’s keeping all investors from going all-in on sustainability?
It’s the difficulty in accessing data and the lack of a standard around sustainable investing.
ESG data comes in two main forms — raw data, mostly from Annual reports and ESG news, and refined data from ESG databases and broker reports. Investors then use this data to come up with a rating. For investors, scanning through annual reports of hundreds of companies is not just extremely time-consuming, but almost impossible. That’s why most investors look at ratings from agencies like MSCI, ISS, and Sustainanalytics, which rely on different methodologies that differ by their breadth of coverage (number of topics covered), or depth of expertise (eg. breaking down environment-related topics to different levels of granularity). It leads to confusing situations when an oil and gas company could be top-graded by one agency and poorly graded by another.
What sustainability topics matter the most?
To comprehensively evaluate the extra-financial aspects of a company, investors generally focus on the following dimensions -
👥 Human Capital: Evaluating the quality of relationships with internal stakeholders (e.g employees, freelances, unions), as well as assessing the company’s practices around human capital issues such as workers’ health, safety, gender pay gap, internal mobility, and equal opportunity hiring
🗣 Communication: Monitoring communication standards by gauging transparency of the communication, quality of reporting, reliability of the data, and the granularity of the insights provided by investor relations and management. Also, assessing the trustworthiness of management’s objectives
🚀 Technological Disruption: Determining how they handle technological disruption (e.g. internet and e-commerce, renewable energies, mobility), and how the value of their assets could be written-off in case of an adverse technological shift
🌎 Social Impact: Assessing the quality of the relationships with external stakeholders such as local communities, suppliers, customers. This could include deep-diving into the company’s sustainable sourcing initiatives, looking for payment delays in the supply chain, public image
🌿 Environment: Determining the positive or negative impacts of the business model on the environment. This could include pollution and toxic emissions related topics, energy consumption, carbon footprint, threats to natural ecosystems
🏢 Corporate Governance: Evaluating whether the distribution of power is balanced between all shareholders and related counterparts. This could include investigating who decides, who manages, which are the ruling bodies within the company. Consider auditor, board, and management-related topics
đź“‘ Audit and Compliance: Assessing the quality of internal auditing, compliance and internal control procedures, and risk management initiatives. This can also include cybersecurity mitigation, product safety checks, and resilience of internal processes and post-incident recovery plans
💛 Business Ethics: Probing into the company’s involvement with corruption, controversial geographies, lobbying initiatives, anti-competitive organizations
🔏 Regulation: Assessing the management of the regulatory framework and the resilience of certain business models with respect to changes in regulations (plastic ban, internet access, pricing constraints) or changes in IP frameworks that might impact R&D-related intangible assets (seeds, healthcare products)
How can investors stay better informed?
The most common practice right now is to just gather and consume as much information as possible. Apart from relying on the agency ratings, websites like ESG Clarity and ESG Today are the primary sources of such information for most investors.
This takes us back to the issue of data overload and how investment professionals are losing valuable time scouring through massive piles of information. We don’t think the solution lies in reducing the amount of information consumed or analyzed, but rather, expediting the process and doing so efficiently. Currently, there exists a couple of social listening platforms like Meltwater, or Dataminr that try to filter the noise and get to the relevant information faster, but they are not the best options for investors and are instead built for communication and marketing teams.
Research suggests that the advent of sophisticated Machine Learning and Natural Language Processing is driving this change and tools like the one we developed at Thread (that extracts crucial SDG-related insights from tens of reports into actionable insights within minutes) will become valuable in deriving crucial extra-financial insights, in the search for alpha.
