Why ESG Investing Matters To Non-ESG Investors
AlphaWeek’s Greg Winterton caught up with Alex Edmans, Professor of Finance, London Business School, to discuss some of the findings in his new upcoming book ‘Grow The Pie: How Great Companies Deliver Both Purpose and Profit’.
GW: Alex, thanks for taking the time. One of the points of your book is that it is possible for companies to create profits and add social value. Tell us what you mean about ‘The Pie-Growing Mentality’ and why you think it’s important.
AE: Some corporate managers run their companies based on a pie-splitting mentality. The pie represents the amount of value that their company delivers, which can be split between shareholders and stakeholders. Managers’ goal is to increase shareholders’ slice of the pie. If the pie is fixed, the only way to do that is to take away from others. What I want to highlight is the pie-growing mentality – you can increase shareholders’ slice by growing the pie for all stakeholders, rather than taking from others. When you are investing in workers, for example, you’re not giving them your slice, you’re making them more productive. In one of my own academic papers, I looked at the 100 Best Companies to Work For in America – a widely respected measure of employee satisfaction – over a 28 year period and compared them to companies in the same industry, or with similar characteristics, not on the list. Companies on the list outperformed their peers by a compounded 89 -104% over that time. By investing in stakeholders, shareholders are ultimately better off.
GW: ESG means many things to many people – indeed, it’s possible for a hedge fund to focus on just one of the three pillars of the ethos when analysing a stock. But which parts of ESG actually works?
AE: The evidence is nuanced. Some claim it always works – in October 2019, Hargreaves Lansdown sent an email to their customers claiming that “study after study has shown that businesses with positive ESG characteristics have outperformed their lower ranking peers”, which is actually not true. There is a lot of confirmation bias in ESG; people like to believe that virtuous companies perform better. The goal of academic research is to look at it in an objective way and let the data speak.
Governance is the one where there is the strongest evidence because it’s easiest to measure. Shareholder rights are a good example of this; where there are more takeover defences installed by company management, long-term shareholder returns are generally lower. Note that this evidence goes against the mantra we see in Silicon Valley. Founders argue that you need protection mechanisms, such as dual-class shares, to protect their vision against allegedly short-term investors. But research shows that the idea that the entrepreneur is a visionary and that outside investors add little simply isn’t true. Adam Neumann at WeWork is a prominent example of the danger of unfettered control.
It’s important to point out that the evidence isn’t universal, and so investors must guard against a box-ticking approach to ESG. Governance doesn’t matter so much if the industry is competitive, because there are already sufficient incentives to ensure that the manager works hard. It mainly matters in non-competitive industries such as utilities. Since there is no competition to make sure the corporate manager doesn’t slack off, governance is particularly important.
One thing I’d like to point out is that the Environmental pillar isn’t as additive to returns as most people think. The evidence shows that it only matters in industries where the environment is material – e.g. mining, but not banks. Doing well in ESG factors improves returns but only when you’re doing well in the material factors. For banks, other factors such as fair marketing and advertising are more material.
GW: So, now we know which areas of ESG to focus on. What do businesses need to do to make sure that the pie actually does grow?
AE: Companies need to be driven by a purpose: the company’s reason for being and the way in which it will grow the pie. Purpose answers the question: “How is the world a better place by your company being here?” It’s critical for purpose to be focused. A good analogy is personal purpose. Someone might want to be a teacher, a doctor or a lawyer, but they shouldn’t try to be all 3. They focus on their strengths. Companies should be similarly focused. Some might say they care about the environment, their employees, their shareholders and their customers. That sounds inspiring, but is unrealistic as there are trade-offs – if a company is thinking about closing down a polluting power station, that would help the environment but help employees. So a purpose statement which tries to be all things to all people provides little guidance on how to navigate these difficult trade-offs.
GW: ESG investing critics say that it’s difficult, if not impossible to truly implement an ESG-compliant investment policy because of the lack of agreement between ratings agencies and data providers. What’s your rebuttal to that?
AE: The first thing to say is that anything that is relevant is difficult to measure, ESG or not. A traditional investor cares about the management team, right? That’s subjective. What makes a good manager? There are no unambiguous measures of a good management team. This means that they are the ideal thing to use as the basis of an investment decision. Everyone knows what dividends and profits and earnings are and the market will price that in. There is a huge advantage to considering things like ESG which are difficult to measure. Because other investors may get it wrong – for example, ignoring materiality or having a one-size-fits-all approach that ignores a company’s strategic context – there’s a large payoff to getting it right.
GW: Your book also says that responsible investing isn’t just an optional extra to be considered only by socially responsible investors – it’s financially material. What needs to happen for ESG be the ‘new normal’?
AE: Two things. First, recognise the importance of the pie-growing mentality. Even if you’re an investor like a hedge fund manager, who cares primarily about financial returns, you should care about ESG. Caring about stakeholders isn’t at the expense of profit, it supports profit. Second, investors should not be hung up about the previous question – the difficulty in measuring ESG. While this does mean that they can’t fully rely on ESG ratings, it means that they can add value by the traditional, boots-on-the-ground approach of talking to management. When you hire someone to work at your firm, you see their resume and grades, but you interview them nonetheless to try and understand if you like them, and if they’ll fit into the culture. It’s the same with investors – they should interview management. If you ask a CEO about how they invest in their people, some will be able to answer, others will tell you to ask the HR director. That’s telling.
And they can meet more than just management. When you look at legendary investors like Peter Lynch or Jeffrey Ubben, when they’re looking at a retail stock for example, they actually go to a shopping mall. If hedge funds are to justify their existence in a smart beta, automated world, they have to look at these intangible factors that machines can’t measure.
GW: Finally, Alex, you’ve been researching and commenting on the ESG space for a while. What would you say to hedge funds reading this who are still yet to formalise and implement an ESG-compliant investment policy?
AE: This [ESG commitments] is how companies create value. Intangible assets are often referred to as “non-financial” factors, but research shows that they are “financial” in the long-run. Some say that Growing the Pie – the idea that both shareholders and stakeholders can benefit - is too good to be true, but it’s supported by evidence, not wishful thinking. I’d also like to stress that my book also presents the evidence against the idea that ESG pays off, rather than being one-sided advocacy. I acknowledge and take seriously the challenges to ESG that you’ve asked me about, and state that the evidence isn’t all-one way (for example, governance doesn’t always improve returns). The discerning hedge fund manager looks at both sides, but on balance, the argument suggests that ESG matters even to non-ESG investors.
Alex Edmans is Professor of Finance at London Business School. ‘Grow The Pie: How Great Companies Deliver Both Purpose and Profit’ will be published on March 26th. Pre-order here.
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