A new investment philosophy that is taking the world by storm

Over time, Environmental, Social & Corporate Governance (ESG) aspects have become very important parameters to evaluate a company’s investment worthiness & it’s inclusion in the portfolio. It is also sometimes referred to as Socially Responsible Investing (SRI).

Understanding ESG

Corporate governance gained currency as an important parameter for fund managers to evaluate companies.

Good corporate governance ensures that the company follows good principles like transparency in data sharing, quality & diversity in the data being shared, ethical & fair conduct of the business, fair & transparent compensation for employees, well laid down policies that take care of the interest of all stakeholders, including small shareholders. 

Good corporate governance will also come from an empowered professional team that works in line with clearly laid down roles & responsibilities based on enshrined process & principles in various areas.

As can be seen, such parameters would ensure that the company that adheres to high standards in corporate governance is bound to be a well-run company, is profitable & a sustainable business.

Over time, social responsibility also started catching the consciousness of the world at large. Investors want companies that make the cut socially, be it equal opportunities for those with disabilities, disadvantaged groups like LGBT, women empowerment, women leadership at the top etc. Research done in this area shows that companies which have good ethnic diversity & inclusion of women in the workforce do better than the broader set, even on financial parameters.

In this era of environmental degradation and all-round concern & activism, it any way makes sense to be a company that is environmentally conscious. It makes total business sense as it reduces regulatory & governmental risks if the company concerned is doing all the right things environmentally. Also, even the consumers are expecting & demanding a responsible corporation that is environmentally conscious.

Hence, ESG is a good screen to apply over other financial parameters and the shortlist that come out will tend to be excellent investment candidates. It is hence a desirable attribute for all companies and can be used as one of the selection criteria itself. 

Applying ESG Criteria

Sometimes ESG criteria may be used to exclude certain companies based on ethical, religious & political beliefs. Companies dealing in gambling, tobacco, alcohol, fossil fuels etc. may form the exclusion list.

At other times, ESG principles may mean achieving certain goals based on investor beliefs. For instance, the goal may be to work towards lesser usage of chemicals in our day to day life. A company that produces products ( say cleaning agents using organic, non poluting compounds ) that do not use harmful, polluting chemicals is an attractive investment choice for someone with such a goal.

There are those who are looking to make a positive social impact. This category is called Impact Investing.  An example of this is an investment in a company that sources & markets bamboo products produced by a rural community, creating a sustainable livelihood for them. Another example is investing in businesses that work with children from the lower social economic strata and prepare them with the knowledge & skills required in today’s world.

International experience

ESG investing has been in existence for long in the western markets. 

Inspite of that, there have been several scams that had happened abroad. Enron, Worldcom, Tyco International are some names that we have heard in the past. 

In recent memory, the transfer of money from customers’ accounts (by salami slicing), by employees of Wells Fargo was a recent scandal. The Volkswagen was embroiled in a major corporate fraud when it installed a cheat software to under-report pollution levels in its vehicles.

The ones mentioned abroad is but a small fraction of corporate malfeasance over the decades. There have been multiple cases of frauds in India too. 

That is where a ocus on ESG comes in as a good hygiene factor to separate out the good companies from the bad apples.

ESG factors seem good; but what about performance

There are multiple ESG indices abroad and most companies report their compliance to ESG parameters, which is considered by the fund managers when they invest.

The best part is that ESG funds have been able to outperform their counterpart index across geographies. To illustrate, I’m sharing some of the indices by MSCI across geographies. The ESG index in the US, the ESG index for emerging markets & even the MSCI ESG index on India has outperformed the base index.

Currently, there is no SEBI defined criteria for an ESG fund. ESG funds are classified as a thematic funds currently.

In Nov 2019, SEBI has made it mandatory for the top 1000 listed companies to prepare a Business Responsibility Report (BRR). This report indicates the level of adoption of sustainable & responsible business practices to the stakeholders.

Now there is an index called NIFTY 100 ESG TRI that has 88 companies that are a part of this index. This is spread across 16 sectors, the top sectors being Financial Sector, IT, consumer goods, energy & automobiles.

There are three funds that have been launched based on the ESG theme as of March 2020. The funds from Axis MF & Quantum MF are less than a year old and do not have any long-term track record. We will need to wait for some time for the track record to build up.

Is following an ESG standard good while constructing a portfolio?

The firms that have internalized the essence of good ESG parameters are anyway good businesses – as ESG is embraced first by those at the forefront. So ESG becomes a virtuous selection criterion, in that the ones that have good ESG scores are good companies with enlightened managements to start with. Such compliance also ensures that the compliance risks & regulatory risks become lower and lessens the business risk itself.

Since the public at large has become very aware of ESG parameters, a company that scores high on these parameters can publicise these & derive real business advantages due to this.

ESG standards appear optional today. Going forward, they will be necessary factors to incorporate in every company.

Investors from abroad are looking at ESG parameters in a very serious way. Hence, if India is to continue to attract money from pension funds, sovereign funds and other institutional funds, it has to take ESG seriously.

It may look like a theme today. It is actually a set of very important mother factors, which any good business will have to incorporate to ensure continued business sustenance. It also needs to do this to increase shareholder value, as without a high score on ESG parameters, the company in question may not have many takers as well.

It is still early days now. But ESG is a major trend & not a fad. We need to understand this.