The value and fortunes of modern companies are increasingly tied up in intangible factors and linked to big macro trends like climate. That requires a new type of analysis. Responsible investing incorporates environmental, social and governance (ESG) analysis into the investment decision-making process. In this article, we lift the hood on responsible investing and explore how it can help investors make better informed investment decisions.
Traditionally, most companies had the majority of their value tied up in hard assets, such as factories and plants.
But in the modern economy, more and more companies have significant value tied up in intangible assets – things like brands, talent, intellectual capital and relationships with the community and environment.
At the same time, these companies are facing big macro factors, such as climate change, that have a significant impact on their businesses.
So to value and assess companies, it is becoming increasingly important to consider factors beyond traditional financial measures such as capital expenditure, costs and earnings.
Responsible investing incorporates a broad range of issues that may have a material impact on the risk and return characteristics of investments into company analysis.
These issues may be driven by existing or future regulation, reﬂect issues of signiﬁcant societal concern, or pose potential operational, ﬁnancial, strategic, reputational or systemic risks.
The issues can be broadly broken down into three main groups:
- Environmental: Natural resource use and degradation (e.g. water scarcity), waste, pollution, greenhouse gas emissions, climate change, clean technology products and services, environmental management practices.
- Social: Human capital, workplace health and safety, labour relations and standards, human rights, demographic changes, supply-chain and community impacts.
- Governance: Board composition and independence, executive remuneration and incentive plans, corporate accountability structures, compliance, negligence, bribery and corruption, conﬂicts of interest and related-party transactions, shareholder rights, accounting and audit quality.
ESG factors provide significant insight into a company’s management, earnings sustainability and business model.
Sometimes, the direct earnings impact of individual ESG issues is small, but the way a company deals with its ESG issues is the value-add. It is this that provides investors with unique insight about the quality of management.
Share prices can also be significantly impacted by drivers that are not necessarily found in financial statements, such as a company’s culture, its occupational health and safety performance and its supply chain risk management.
And if the business model relies on under-priced pollution, under-paid labour or weak regulation, the current earnings levels might not be sustainable.
The benefits of ESG analysis
Many sustainability issues may be known to the market, yet the implications for investments can be complex. But in-depth ESG analysis successfully integrated with financial analysis can provide investors with significant benefits, including:
- Better informed investment decisions
- Early identification of investment risks
- Identification of mispriced securities
- Potentially higher investment returns – both in the short and long term.
There are clear links between an organisation’s environmental and social impacts, the quality of its corporate governance, and its long-term business success.
With the growing complexity of modern organisations ESG factors and analysis will help investors find those companies best placed to navigate – and thrive – in this environment.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.