Why ESG investing matters to everyone and how to use it to future-proof a portfolio

Environmental, Social and Governance (ESG) investing has been at the top of our minds recently. Some US lawmakers have argued these metrics have no place in modern-day investment strategies. But saying ESG should be side-lined completely is akin to telling investors to disregard conventional metrics like price to earnings or free cash flow.

There’s room for a debate over just how front-and-centre ESG should be when it comes to different investment strategies. But abandoning it completely would be sticking your head in the sand.

To understand how ESG can impact your investment decisions, it’s important to first understand what exactly it means.

What is ESG investing?

All investors fall somewhere on a responsible investment spectrum.

Those who invest to make change in the world and expect no financial return are considered philanthropists. On the opposite end is a group that expects solely financial returns and is completely unbothered by the positive or negative impact of their chosen investments. But the majority of investors fall somewhere in the middle. It’s this group that will find ESG metrics useful.

Investors using ESG metrics might care deeply about climate change, or they might not believe it’s real. But their eyes are open to the trends influencing regulatory decisions, government policy, and public perception.

Sustainable has become a green buzzword in recent years, but the essence of this word works perfectly with the use-case for ESG investing. Sustainable companies are those that will stand the test of time because they’re able to change with the times. ESG metrics are one way to help investors measure risks and opportunities in this realm.

More on ESG and how it fits in with responsible investing

How to use ESG

In order to adapt ESG metrics to specific investing goals, it’s useful to understand how they work.

Data and reporting in this sphere are few and far between, meaning ESG scores can vary from source to source. But like any other financial ratio, it’s important to compare similar companies within similar industries. Each industry has unique ESG risks, and some might be harder to overcome than others.

This article is not personal advice. As always, if you’re not sure about an investment decision, seek advice. All investments fall as well as rise in value, so you could get back less than you invest.

Taking a best-in-class approach

Many assume that ESG investing excludes particular industries like oil and gas. But this isn’t always the case. Investors with a sustainability focus can use ESG metrics to find companies that are leaders in their industry.

This is particularly important for sectors experiencing a shift – like oil and gas. Given the push for renewable and clean energy around the world, investors could use ESG metrics to find oil and gas companies with the best chance to benefit from the shift toward sustainable energy.

Governments will be doing all they can to incentivise new technology that will help the transition away from fossil fuels. This opens the door of opportunity for businesses able to make that shift. Companies set to benefit from this are those who are continuously improving their ESG profile with net-zero pledges and investments in renewable and green energy.

By using ESG in this way, investors can maintain a diversified portfolio without disregarding the underlying shift toward a more sustainable society.

ESG to identify risks

One way to use ESG metrics is for risk management. All investments come with some level of risk and there are many types to consider. ESG risks can create major roadblocks for long-term investors.

The auto industry offers a good example of how ESG metrics can help investors make better decisions. It’s a sector that’s seen a great deal of change over the past decade as it shifts away from petrol-power and toward electric vehicles (EV).

Take Johnson Matthey, for example. The group’s been a successful manufacturer of catalytic converters, the bits that strip out some of the harmful emissions from petrol cars, for years. But as concern for the impact these vehicles have on the environment grew, so did the environmental risk at Johnson Matthey.

Johnson Matthey share price

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Past performance isn’t a guide to the future. Source: Refinitiv, to 27/09/22.

In July 2021 the UK announced a ban on the sale of new petrol vehicles by 2030, and the group’s share price has been in decline ever since. Johnson Matthey’s core business became very unsustainable and the group’s struggled to find ways around that without much prior preparation.

This risk has been hanging heavy over the auto industry for years. It’s now coming home to roost for companies that haven’t started to pivot toward sustainable alternatives.

The environmental side tends to get a lot of attention, especially as climate change makes its way onto political agendas around the world. But social and governance can be just as important to pay attention to.

American bank Wells Fargo’s fake account scandal offers a window into what can happen when governance issues crop up.

A high-pressure environment with excessive focus on daily targets and quotas, led employees to open new accounts and issue new credit cards to customers without their knowledge. In 2013, the scheme first came to light. Although Wells Fargo’s renumeration policy relied heavily on this cross-selling, the bank shrugged off worries about an overbearing sales culture.

Over the next three years the scandal ballooned, showing it was a wide-spread issue. In 2016, Wells Fargo found itself struggling under regulatory and criminal investigations. At the end of 2020 the bank finally closed the book on these enquiries, agreeing to $3bn in penalties. But the highly-publicised scandal remains a black mark on the bank’s reputation among both investors and potential clients.

Wells Fargo share price

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Past performance isn’t a guide to the future. Source: Refinitiv Eikon, to 27/09/22.

ESG to identify opportunities

ESG investing is about more than abandoning risky stocks – it’s also a good way to identify opportunities in a sector that’s ripe for a change.

Using the auto industry once again, Tesla is a great example of this. The electric vehicle maker spent years under the microscope as analysts argued over whether the group would ever become profitable in its own right.

At the time, the government was offering regulatory credits for companies making electric vehicles. Since that was all Tesla made, the group was able to get the credits for free and sell them on at a profit to other carmakers. The regulatory credits made up the lion’s share of the group’s first positive operating profit in 2020.

This can often be the case when it comes to new technology or revolutionary business models. Initially unprofitable, they’re sometimes able to shoot the lights out at scale. This is the reason many environmentalists take aim at the government. Without regulatory intervention or government support, these sorts of businesses would likely struggle to get off the ground.

Tesla share price

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Past performance isn’t a guide to the future. Source: Refinitiv, to 27/09/22.

For those who saw Tesla’s ambition to churn out electric vehicles at scale as a smart move away from petrol, the stock offered enormous opportunity. In this instance it paid off, despite coming with a multitude of other risks.

Notably, Tesla was recently excluded from the S&P 500’s ESG index. This comes as a blow given the carmaker’s position as an EV proponent. However, concerns about working conditions and a rise in the number of accidents mean the group’s overall rating has been dropping as peers improve their own environmental credentials.

That’s why it’s important to keep an eye on the S and G side of ESG ratings as well.

American clothing retailer American Eagle’s performance over the past near-decade is an example of how cultural changes can impact brand strategy. In the early 2000s, Abercrombie & Fitch had made a name for itself as an aspirational brand for young people. But the group was at the centre of discrimination lawsuits for excluding applicants if they didn’t fit a certain look.

American Eagle pivoted in the other direction, focusing on inclusivity. The strategy started with a 'no-airbrushing’ policy within its intimates line in 2014. This ballooned into a social media campaign and the use of models who are famous for something other than their looks. The result was growth far and away from other players in the industry in 2018 as the group found a foothold in a growing trend toward body positivity.

American Eagle share price

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Past performance isn’t a guide to the future. Source: Refinitiv Eikon, to 27/09/22.

The key takeaways for investors

ESG metrics will vary in importance depending where you sit on the responsible investment spectrum. But the important takeaway is paying attention to ESG is more than being a climate crusader or driver of social change.

It’s about finding businesses that are adapting to our changing world.

Investments in renewables are not only good for the planet, but they’ll also pad the bottom line as prices rise. Diversity among employees will keep companies from pigeonholing themselves and offer growth opportunities in an ever-changing social landscape. And transparent governance will avoid costly missteps and a tarnished reputation.

ESG investing is one way to judge whether a company is a good corporate citizen, and that will translate into more sustainable operations down the road. That’s why all investors should start to pay attention to ESG issues as part of a balanced strategy.

ESG investing is also a relatively new concept, so the data needed to make these kinds of assessments is limited. A good place to start is company annual reports, which almost always have some type of ESG disclosure.

We’ll do a lot of the legwork for you, offering insight on potential ESG threats as well as detailed financial analysis on over 100 of the most popular stocks.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

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