For much of the last hundred years or so, investment decisions have tended to be framed primarily in terms of a hard-nosed assessment of just one thing – shareholder value.
However, over time this single-minded focus on the shareholder has progressively given ground to a broader assessment of corporate merit that includes consideration of external concerns and the impact a firm has on a wide range of stakeholders. There have been a few iterations of terminology to describe this broader focus, but today we know it as Environmental, Social and Corporate Governance (ESG) investing, and it addresses a broad range of considerations including climate change, finite resources, management and board diversity, consumer protection, animal welfare, employee relations, director independence and remuneration.
ESG investing is an increasingly important force in investment markets, and even if your preference as an investor is to focus squarely on maximising your financial return, it is a trend you need to understand.
Some historical background
In 1970, economist Milton Friedman produced an essay for the New York Times titled A Friedman Doctrine: The Social Responsibility of Business is to Increase its Profits. The Friedman Doctrine argued that a corporation has no social responsibility to society; only a responsibility to shareholders, and that a company executive spending money on social causes is, in effect, spending somebody else’s money for their own purposes.
The Friedman Doctrine had a big influence on the corporate world; and you can hear its echo whenever you hear a CEO utter the expression “maximising shareholder value”. However, over time the doctrine has attracted increasing criticism, with concerns including that it promotes short-termism and bad conduct and has the effect of impoverishing many to benefit an elite few.
While the Friedman Doctrine was widely accepted and influential, there have always been some investors who include considerations of social good as part of their decision-making. In a Friedman world, these investors needed to accept a lower expected rate of financial return as the price for pursuing other goals.
Around the turn of the century, however, journalists Robert Levering and Milton Moskowitz brought out the Fortune 100 Best Companies to Work For, a book compiling a list of the most socially responsible companies in the United States and analysing their performance. This analysis argued that improving social responsibility did not damage financial performance, but instead improved productivity and efficiency and attracted superior management talent. This was followed by other work that supported the idea that the most socially responsible companies had in fact delivered superior investment performance to their peers.
This opened the door to a new class of investors who included social considerations in their decision-making but did not expect to suffer for it in terms of returns.
More recent developments
Friedman argued that corporates should ignore those costs imposed by the corporate on society but not directly borne by shareholders. This implied, for example, that a company that polluted the environment but did not bear any direct cost for that pollution should ignore the pollution in its decision making.
Today, however, there is a heightened and growing level of awareness and concern around these types of externalities, and offending corporates find themselves exposed to the very real risk that regulatory change, market evolution or stakeholder activism may shift these societal costs back to their point of origin, or severely curtail them. An investor who commits capital today to develop a new coal mine needs to consider the risk that the energy market will have moved away from them before they earn an economic return.
In simple terms, corporates today that do not offer a truly sustainable “value” proposition to all relevant stakeholders may find that they lose the support of employees, banks, investors or customers, all of which can have very direct consequences for shareholder value. This means that all investors – not just those with a desire to drive positive change in the world – need to take account of the practices and sustainability of those companies they invest in.
At Montgomery, our goal of preserving investor capital and delivering outperformance means that we need to focus on these questions, and while we do not explicitly market ourselves as an ESG investment house, hopefully you will not be surprised to hear that our portfolios typically achieve very high average ratings based on the third party ESG scores awarded to individual portfolio companies. Over time, we expect that these considerations will only increase in importance, and we aim to ensure that our investors are on the right side of this continuing trend.