Sustainable and ethical investing go mainstream

© 2009 Michael Lannon

Australia is now the world’s fourth-largest managed funds market. Many Australian investors are concerned with how their money is invested and the impact of their investments on the environment, which is resulting in an increased interest in and awareness of sustainable investing.

Sustainable investment considers social and environmental factors as well as traditional financial analysis, and can become a powerful tool to encourage companies to become more environmentally sustainable. But the question most often asked by investors is: “Can I support sustainable or responsible investing without having to accept lower returns?”

There are a number of ways fund managers select ‘responsible’ investments; for example, positive and negative screening (including or excluding a company on the basis of its industry), shareholder activism, or analysis of a company’s environmental, social and governance (ESG) issues.

The trend for fund managers to incorporate ESG issues into their investment process has gathered pace, as evidenced by the take-up in Australian signatories to the United Nations Principles for Responsible Investment (PRI). Let’s look at how applying ESG research works in practice.

Valuing the company below the line: evaluating intangibles

If regular analysis of a company only covers 23% of its total value, most investors would be asking “what about the other 77%?” According to research by AMP Capital Investors, some 77% of company valuations could be attributed to ESG issues, or ‘intangibles’, which include factors such as employee and customer relationships, supply chain and intellectual property.

These intangible factors can have significant bearing on a company’s returns. In answer to the previous question about returns, consider the fact that in the year ended 30 June 2007 the median sustainable fund outperformed the S&P/ASX 200 over one, two, three and five years. Investors should note that past performance is not a reliable indicator of future performance.

This superior performance highlights that analysis of companies’ social and environmental credentials can provide insight into selecting better performing companies. Fund managers who are concentrating on sustainable investing are developing techniques to identify issues and investigate, value and model ESG issues into practical models that make for a transparent investment case.

Michael Anderson, AMP Capital’s director of sustainable funds, says: “The majority of true valuation lies off balance sheet in intangible factors, and funds that consider these intangibles when selecting investments have an advantage on other investment managers who aren’t poking their head below the surface.

“We do think there is a lot of room for rigorous and scientific analysis [of ESG issues], and there is science that can be brought to bear on the process. There is also the issue of judgement, just like there is in all aspects of finance,” he said.

Anderson highlights the example of supply chain risk. The sustainable investment fund’s analysts will examine a company’s supply chain in depth and if a supplier is open to risk – for instance, if a manufacturer outsources to a provider who may use child labour – there is quantifiable, if intangible, risk to a company’s brand, sales and therefore valuation. That impact may be severe and any investors would definitely want their fund manager to be across it.

Integrating ESG research into the stock selection process

Many proponents of socially responsible investing or ethical investing use a process of screening or eliminating stocks from the universe based on ethical or moral grounds. While this may help weed out the bad guys, it does not quantify or objectively deal with many of the viable contributors to the long term success of a company.

In contrast, using ESG research and integrating it into the financial valuation of a company can result in better analysis of a company’s prospects. Poor valuations in any of the identified ESG categories will raise the risk profile of a company and thereby affect its valuation and the case for investing in that company.

Therefore, the bigger the ESG risk a company runs, the bigger the hurdles it will need to clear before being considered for investment. In summary, it appears that investors wanting to support sustainable investing can do so without having to accept lower returns and often the result is superior returns when a rigorous research process is brought to bear.

Article provided by Michael Lannon. 2020 DIRECTINVEST is an online investment broker for Australian managed funds and superannuation funds with no entry fees.

This article contains general information only and does not take into account the particular financial situation, objectives or needs of individual investors. Investors should consider whether this information is appropriate in light of their particular financial circumstances before investing, and if necessary seek professional advice.

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Michaell Lannon is the Managing Director of 2020 DIRECTINVEST, a boutique investment company offering direct access to managed funds and super funds without entry fees and adviser service fees. He has more than 20 years experience in the financial services industry, initially with Merrill Lynch in Canada and Australia before founding 2020 DIRECTINVEST, and is a vocal critic of inadequate fee disclosure and commission-based financial advice.

This article contains general information only and does not take into account the particular financial situation, objectives or needs of individual investors. Investors should consider whether this information is appropriate in light of their particular financial circumstances before investing, and if necessary seek professional advice.