Knowing a company’s ESG makes knowing its SLY so yesterday.
The fundamental Safety, Liquidity, Yield principle (SLY) for portfolio management is becoming so yesterday. As if there weren’t enough to think about when reviewing and selecting investments, some firms are adding a few new variables to consider; one is ESG, or Environmental, Social and Governance issues.
ESG considerations are growing because corporate investors unknowingly could be exposed to much more than losses associated with the actual investment. They could also be exposed to the potential of a tarnished reputation by association with a company that has failed in one of these publically or politically sensitive areas.
And the issue is becoming so important that ESGs are beginning to be included in credit reviews and are even having an impact on the pricing of some securities. Risks associated with these variables have been very real for a while but the proliferation of social media has made the exposure to those risks, and even worse, the consequences of failure around them, all the more significant.
Kevin Bannerton, managing director at DB Advisors and Jeffrey Power, director of global investments at eBay, recently discussed this topic at the November AFP Conference in Boston. Mr. Bannerton noted that there has been growing interest among investors for companies to show more ESG responsibility in their portfolios. He highlighted a few examples including the BP Deep Water Horizon disaster. Under normal circumstances, an institutional investor evaluating BP would naturally perform the typical due diligence such as reviewing financials, CDS spreads and credit ratings. But Mr. Bannerton pointed out that a review of publicly available information about BP’s employee safety training would have revealed that the company’s record was substandard to the industry. One could then conclude that there was too much risk of a safety event with such an investment.
Other examples include companies’ data security and privacy practices as social exposure risk, or the lack of diversity and independence of board members, as an exposure to governance failures. Considerations of this nature are becoming more accepted as additional components of fiduciary duty. Further, the impact of these considerations is beginning to show up in indicators such as credit spreads and CDS pricing. “Markets are starting to price in the differentiation between companies and it’s becoming more mainstream,” Mr. Bannerton said.
EBay’s Mr. Power also pointed out that while fundamental credit assessments are critical there is now a far greater need to dig deeper for those less transparent risks that, admittedly, require more resources. “The cost of doing this right is higher,” Mr. Power said. But he added that eBay is committed to this new level of review enough to hire, “very seasoned people for the task.” Mr. Power also noted that there are three responses to ESG risk discovery:
- Avoid it – having determined the risk is too great.
- Buy it – having determined that the price reflects an acceptable risk.
- Wait – for a better buying opportunity having determined the investment is desirable.
Mr. Power cautioned not to wait for an event to figure out how to respond. “Companies should have a framework in place for managing potential headline risks,” he said. “Social media puts a rapid magnifying glass on any missteps,” which could quickly overwhelm even the most prepared PR department.
Mr. Bannerton noted that DB Advisors has developed a full process for including ESG research in its investment evaluations but also said that ESG risks are generally not readily quantifiable. However, “debt issuers with poor communication on ESG issues will likely have less favorable pricing in the market,” he said.