Values to value-based investing: the evolution of sustainability

Our thoughts:

Investing is often a long-term endeavour, especially if you are looking to weather through equity market volatility to invest for retirement. While financial metrics such as PE ratio, market capitalisation and dividend yield are still relevant in assessing a company’s performance, these historical data may no longer be predictive of a company’s long-term performance.

Read on for expert insights from global asset manager Franklin Templeton on how value-based investing and ESG metrics can help build a more robust portfolio for long term investing.

The concept of investors aligning their financial goals alongside certain values has been a feature of socially responsible investing for decades. This idea has garnered tremendous interest more recently, leading to a variety of approaches. This paper discusses the evolution of the industry to date and various methods of incorporating Environmental, Social and Governance (“ESG”) considerations in a portfolio.

Corporate conscience, the millennial voice and alternative data: trends in sustainable investing

The quarterly earnings cycle, 24 hour news and constant barrage of social media—it seems with every decade that passes comes an increasingly heightened focus on the “now.” Technology has spurred this transformation, rapidly evolving how people communicate and interact. It affects everything from corporations’ intensified focus on short-term profits over long-term investments, to the soundbites that dominate thoughtful political discourse today. In contrast with this short-termism, a growing number of market participants have pledged to take a long-term view on investing through sustainable initiatives. “Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.”(1) This concept includes an individual’s footprint, but also encompasses the viability of a company’s future, and thereby, can be viewed through the lens of investment returns.

Growing investor demand has also been fueled by support from leading asset owners and financial institutions, acknowledging their intergenerational commitments and thus having an inherently long-term view. In 2006, 63 investment companies representing $6.5 trillion in assets committed to alignment with the United Nations-supported Principles for Responsible Investment (the PRI); today there are over 2,200 signatories representing over $80 trillion in assets.2 The PRI was predicated on the idea that companies and investors should take into account the implications of their holdings with respect to the world’s environmental, social and governance (ESG) goals. The term ESG covers a wide range of complex and often interrelated issues, such as water management, community relations and board structure.(3) Over the years, the PRI has challenged fiduciary responsibility, sparking the conversation on whether non-financial data, such as a company’s ESG characteristics, should be considered in light of investment decisions. Signatories to the PRI commit to incorporating ESG issues into their investment analysis as well as ownership policies and practices. Today, over 73% of investment professionals worldwide surveyed by the CFA Institute consider ESG issues in their investment process.(4)

Further underscoring today’s changing cultural environment is the Business Roundtable’s recent announcement shifting its mission statement from a focus on shareholder primacy, to instead prioritizing and considering multiple stakeholders including customers, employees, suppliers and communities as well as shareholders. In this statement, we observe the largest corporations in the United States revising their definition of the purpose of a corporation away from short-term profit maximization to a more holistic and sustainable view of value creation.

Additionally, the millennial generation has been at the vanguard of sustainable investing, demanding more from companies they support and invest in, including greater transparency, a sense of purpose and broader stakeholder and community alignment. 87% of millennials globally believe that the “success of business should be measured in terms of more than financial performance alone.”(5) Empowered through one of the largest generational wealth transfers from baby boomers, and on the precipice of their prime earning years,6 numerous studies suggest that millennials are increasingly interested in deploying capital to those companies viewed as making a positive impact or reflecting personal values. A 2017 FactSet study of high-net-worth investors states that 90% of millennials want to direct their allocations to responsible investments over the next five years.

While it is clear the momentum behind sustainable investing is building, we believe there are many investor considerations in determining how best to meet objectives across financial, environmental, social and governance dimensions.

The business case for sustainability: the opportunity within non-financial metrics

Investors are becoming increasingly aware that ESG issues can have a measurable effect on a company’s value, as well as its reputation. Data measuring ESG can provide additional insights into potential opportunities or risks outside of traditional financial metrics. Value creation takes place in and depends on environmental, social and governance systems. Economic activity that is not sustainable degrades those systems, diminishing their future viability and value. For instance, future regulation could negatively impact firms that produce high levels of emissions, firms treating employees poorly may face a backlash from consumers or future talent, and a firm with inadequate governance may be more likely to be involved in a scandal or controversy.

While the investment professionals have a well-developed language and formal system for measuring and assessing the value created, or destroyed, by financial capital, they do not yet have a similarly robust system to assess the value created or destroyed by the use or misuse of ESG capital.

The UN PRI Global Compact provides a general framework outlining the three ways in which sustainability through the integration of environmental, social and governance issues can lead to a competitive advantage.(7)

Asset owners are now asking companies to appreciate, understand and act upon the tradeoffs that exist between financial and sustainable performance. Sustainable economic activity maintains or enhances ESG systems, increasing a company’s future viability and value. The future value of the investment depends heavily on the future state of the system.

Values to value-based investing: the evolving approaches to sustainability

The concept of investors aligning their financial goals alongside certain values has been a feature of socially responsible investments (SRI) for decades. However, sustainable investing has evolved considerably from the early SRI funds that primarily looked to exclude certain companies irrespective of financial impact.

Increasingly, investors are looking to take a more active stance with respect to their investments, utilizing a “voice” over “exit” approach in many instances. Shareholder proposals filed at companies requesting enhanced transparency to make investor decisions as well as a means to influence overall change have become a primary pressure tactic. For example, the shareholder proposal process recently helped to drive Dick’s Sporting Goods from selling assault rifles, and three years of shareholder resolutions later, Exxon gave way and welcomed former atmospheric scientist and director of the Woods Hole Institute to its board. As a result, ISS and Glass Lewis, which provide shareholder proposal guidance, are increasingly influencing how investors’ voices are heard on certain issues.

Broadly speaking, investors tend to group forms of ESG investing into four primary buckets; however, many investors look to incorporate multiple methods in order to meet their unique objectives.

Conclusion

Now more than ever, investors are looking to form a deeper and more holistic understanding of financial markets and human behavior to better identify opportunities to create, sustain and protect value, while delivering on client objectives. There is a growing need for investment decisions to be considered in a broader context, including risks and opportunities related to environmental, social and governance dynamics which may have long-term benefits on overall investment outcomes. As a firm, we are continuously expanding our research in this area to further refine our understanding of the implementation of alternative insights into the investment process and further explore the impacts of sustainable investing on pricing future risk and return opportunities.

This article was originally published by Franklin Templeton.

Franklin Templeton is a global leader in asset management that strives to create long-term value for clients through the combination of global strength and boutique specialisation. As one of the world’s largest asset managers with AuM of USD $1.5 trillion, they offer deep expertise and specialisation - within and across asset classes, investment styles, and geographies.

Endowus currently has 3 funds (as of 14 July 2021) from Franklin Templeton, namely the Franklin Technology Fund, Franklin Shariah Global Equity Fund, and the Franklin U.S. Opportunities Fund.

Get started building your own portfolio with these funds on the Endowus Fund Smart Platform.

Definitions

An investment factor is a characteristic that can explain the risk and return performance of an asset. It is considered a driver of return for an asset. ESG factor specifically refers to environmental, social and governance characteristics of a company, industry, etc., that helps shape its performance.

Risk-adjusted return refers to a measure that takes into account the amount of risk associated with achieving a level of return. Whereas an investment return simply measures the gain (or loss) of an investment, a risk-adjusted return places that gain (or loss) in the context of how much risk was involved.

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Endnotes

1. Source: United Nations World Commission on Environment and Development, “Report of the World Commission on Environment and Development: Our Common Future”, 1987.

2. Source: United Nations Principles for Responsible Investment Annual Report 2018.

3. Source: G. Clark, A. Feiner, M. Viehs. (2015). “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance”. University of Oxford. Arabesque Partners.

4. Source: CFA Institute, CFA Institute Environmental, Social and Governance (ESG) Survey, 2017.

5. Source: A. Winston. “The Top 10 Sustainable Business Stories of 2017.,” Harvard Business Review, December 23, 2017.

6. Source. Deloitte, 2018 Deloitte Millennial Survey, 2018.

7. Source: Principles for Responsible Investment—United Nations Global Compact LEAD, “The Value Driver Model: A Tool for Communicating the Business Value of Sustainability”, December 2013.

8. Source: M. Khan, G. Serafeim, A. Yoon. (2017). “Corporate Sustainability: First Evidence on Materiality”. The Accounting Review 91(6), 1697–1724.

9. Source: J. Dunn, S. Fitzgibbons, L. Pomorski. (2018). “Assessing Risk through Environment, Social, and Governance Exposures”. Journal of Investment Management 16(1), 4–17.

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