ESG As an Investment Method

Hello, and welcome back to another episode of the long run show. This is Austin Wilson, and I'm sitting alongside my cohost Michael O'Connor indeed.

And today we are going to be talking about E S G environmental social governance investing  a, more of a methodology episode here. We're not gonna be too. Necessarily about specific stocks, although we'll probably get into that, but more on the methodology. Is it helpful? Is it not should you use it in your portfolio?

What to consider if you're going to use in your portfolio really is going to drive the conversation today.  To jump right in Mike, I think it would be helpful if we just give it, give a definition first. So we're sure on the terms  and cover that first, so and environmental, social governance.

Okay. Often throw it around. You want to give a broad level definition real quick? Yeah, sure. Essentially it's the, it, far as I understand, it's the broad understanding and methodology taken to, I believe it comes from real stakeholder methodology and philosophy in business where your company is not operating in a vacuum.

They operate in an environment that consists of the society, that the people who are workers. Consumers who are neither who are just ancillary and around it consists of the natural environment  the physical space, trees, plants all of that. And you have governance you have the regulatory environment, the local state government world level.

 So it's that almost a full stack of different things that are not necessarily directly correlate. The company's bottom line or shareholder value and stuff like that. Yeah. It, and that's where it becomes interesting that this is such a  a hot topic in a world of financial space, normally driven by the bottom line numbers.

 Traditionally that's been the, that's been the number one driver, we get to create shareholder value and that's led to some interesting not. Optimal outcomes with odd externalities that definitely we're not incentivized by just trying to create shareholder value.

So it is it is interesting that we're now getting to this methodology of, okay. Let's look at all the stakeholders. And I remember studying stakeholder kind of methodology in a class in university. So it makes some sense. My. My question is  does it make sense at the investor level?

 Should this be a reason to invest or not invest in a company? Because obviously somewhat the secondary market, so not IPO's, but everything else, the secondary market is somewhat an incentive system for the company. But not always  you're not necessarily, if you're.

And the secondary market, you're not necessarily funding the company. So it's not as a direct correlation or or a relationship as some people might expect, but I do understand the ethical standpoint of, okay. I want to be an owner, a part owner in companies that I believe in and I want to have a framework for deciding that so I can see the impact.

  Might be helpful to give a formal definition as well according to PWC, which is a pretty good source. Environmental side, they say take action on climate issues, minimize to minimize impacts, capture opportunities and deliver value to all stakeholders. And so focused on, like you said, the environmental impact of doing business.

 And then on the social side, creating enterprise value and enhancing public trust by addressing the, and managing, communicating societal commitments. So talking about  what, what happens with. Workforce, what are you doing? What your products and services, how are they impacting the society and the community at large, and then also the local community too?

 So that would maybe include giving back or some charitable work something along those lines and then the governance side, of course making sure all of this is actually implemented. And I actually have the three thing, probably the governance side is maybe the most valuable to the enterprise.

 Because. You can you can give back companies can give a charitable donation, get a tax credit, but actually enforcing any of those things. You have to have the governance side so that the G of ESG is the most important part. So again, getting that out of the way what are your thoughts, do you think it's helpful that we have this framework now?

Does it? I know Milton Friedman was actually very much against. He thought it was ridiculous to say that this was important to businesses.  And that this should be even considered when it comes to the enterprise level of thinking, he thought bottom line is the end all be all.

That's how you measure success. Do you what are your thoughts there? Can we is it just the bottom line or should we be worrying about these as investors? Should we be worrying about these other impacts that business has. And different stakeholders involved. Sure. And I think that there, it's interesting because there have been studies done where they try and measure and kind of show a correlation between ESG activity and profits have seen some studies and read some papers that kind of outline that, that, but the argument out that companies that do good subjectively in ESG You better in terms of their actual bottom line, do better profits.

However, I think one kind of confounding variable in that is that most likely the companies that have the resources to be able to dedicate to ESG are probably doing pretty well already. So I think there's, it's tricky to figure that out. Very difficult to measure. It can definitely be sampling bias.

 So I think it's the bottom line is ESG is a pretty difficult thing to grasp. Especially if you're outside of a company I think it's difficult to like efficiently and effectively judge the real value of ESG, unless you are in-depth inside a company. Cause I think like you said, the governance is very important part of it and unless you're on the board, there's a lot of things that are probably a black box.

 So it's difficult I think to measure and I believe some ETFs and funds that have tried. To save their ESG or even entire hedge funds or instruments that are like, yeah, we're ESG focused. There have been some scandals where you know that then half of their holdings are actually not really doing much.

If anything will come out or one of the big ones will come out and there'll be  there'll be some sort of difficulties in, in vetting that effectively. And so  it's a tricky job to try and. Outside of any, either outside of any company. Now yeah, given that, I think it is, it can be important if nothing else because of brand value and because of perception.

 I think that can be a tangible effect. Probably not easily measurable, but tangible. And at the same time there, there are arguments to be made. If a specific company, the name of the show, The long run.  If a company is if companies producing negative externalities, whether it's environmental or social, et cetera, I guess one example could be, let's say you have a very harsh work environment with high churn is one example that end at work environments are actually becoming more and more of a focus for ESG, which hasn't necessarily been as much in the past as far as I understand, but it's becoming more and more of a focus.

At the end of the day if this company has a very high churn or they're burning through employees, human capital is, it seems like an inexhaustible resource. I'd say for most companies and in the economy, but it's really not. And COVID and remote work and the great resignation and all that has shown that more saliently, I think.

So it depends on the long run and   the kind of environment. And especially the labor economy is just one example where ESG and having some sort of governance may be able to provide tangible value and that you may be, you keep employees for longer, they're more productive, et cetera, et cetera.

So I think there definitely can be value benefits to ESG, but the problem is it's. I think it's very difficult to fully understand those benefits unless you are integrated into that company. Yeah. And that's where that's where I have a tough. I'm using it as a methodology because my to my my, my sense of the situation is that okay.

 If you are a company who is like you said, if you have have high churn you have a negative workplace environment it's very difficult. Or for instance another good one that's an easy historical example is like big tobacco, there's a huge externalities there.

  Causing cancer and your customers or a classic if you're a manufacturer and you're polluting the the Allegheny river down your Pittsburgh or something  that is going to come back and bite you in the buck. So over the long run, it does pay to be playing by these ESG rules for the company.

And I think there's a very good argument that it makes sense from a bottom line perspective for. Company to, to be a good citizen, so to speak. But it make it's like you said, very difficult to make sure that is accurately reported. We don't even necessarily w we don't have the reporting of the financial hard data of companies down to a science yet.

There's a lots of examples of improprieties when it comes to the reporting, the financial data of companies. It's tangible right. That's numbers and that's dollars and cents. So when we're reporting on on the social impact and the environmental impact of a PR one particular company, not only other component variables and not only is there a   an unevenness in the distribution of the information between the outside investor and the inside shareholder, or insight stakeholder, not only that, but it's very difficult to quantify.

So that's why I have  I'm not necessarily against it per se, but it seems like it is being overweighted from an investment perspective, because I don't feel that the data is actually act actionable. It is too. It's not clean enough. The data isn't clean enough for me to go, oh, okay. This person has that.

Cause, cause for instance, when it's used in an investment standpoint, we're talking about like ESG scores where it's like on a scale of zero to a hundred, these guys. Whereas this company is a 75. So I'm going to go with the 95 rather than the 75. There's so many factors that go into how the score is calculated, but then what's the data that went into calculate the score in the first place.

Was that data even good? Does it actually reflect reality or is it fudged a little bit by the company or what have you, so that makes it difficult for me to trust like an ESG framework. So to say so to speak when it comes to. Choosing an investment it, like you said, you don't want to be creating negative externalities that either use it, the resource or  are detrimental to your longterm growth as a company.

 And I think that just, that's more it's almost more common sense and unfortunately common sense is not very common, right? So it's  if people would, especially in  people in management and places. Power steering the ship in the company, if they would use common sense and think forward about long-term growth, maybe yes, you wouldn't have to be such a conversation.

 But we do seem to, a lot of the times sacrifice the long run for the short term, whether it's a financial we gotta meet this quarters growth points at the expense of next year. Decades ability for growth.  Or if it's just I'm going to do this cause I'm a selfish person and this is going to get me my quarterly bonus  there's just, it seems like it's in in the measurement of the thing, it is flawed. It's not necessarily that ESG is bad. It's just that it's flawed in its measurement. And I don't know that could ever necessarily accurately be measured. I'm not sure. Feel free to perspective. No, I think what you said is important because I think there is a distinction to be made between, and this is where my opinions on ESG lie, as well as that ESG is ultimately a management strategy, not an investment strategy.

And I think that while the management strategy is crucial to have as part of the toolbox for a board and C-suite.  The whole company, the whole, it, I think there is a, almost a temptation to pull that out and extrapolate that and attempt to use that as an investment strategy. Whereas investing is in some ways it's a lot easier than running a business in some ways it's a lot, it's a lot easier to lose a lot of money then, but it's, I think that there is a, this idea that any kind of metrics that you can pull out.

The standard business more helps an investment decision and while it's certainly, I think it's certainly true that the more legitimate information you have about a business, the better informed decision you can make. The difficult thing is that I think there's a gap between the value of ESG in a long run management strategy scenario, which I think it is probably high.

It's probably a high value to be able to have a very top down view and. And where your corporation or company exists in relation to all these different factors. I think there's a gap between that value and the value that an investor can or may receive at the same time. There is still perceived value if nothing else.

  The value of feeling like you're supporting companies that are supporting the environment, whether real or not is. It was a factor. And I think that's do you extrapolate that? I think that's a huge draw for people to, to invest in ETFs or to have financial advising and people who don't want to worry about their money at all might be in one category.

But then you have a category of people who are interested in active investing or more passive investing, but choosing their investments. They may still be concerned about exactly where it's not necessarily just for the dollar value. So I think that ESG can bring value in investment scenarios.

But I think, like you said, it's, it seems as if there's a lot of, not necessarily hype, but a lot of talk and a lot of developments going on around ESG that  we saw like with the gigantic Volkswagen scandal, where, how do you, this, there's no way to know that what that's about to happen.

And that's that sticks out in our mind because it's very easy. You to think about. And we have we have that kind of as a heuristic, a bias then that's very easy to think about, but think about all the car companies that haven't done that, but at the same time, it's we know that's a possibility.

 We know that ESG numbers are fungible in a lot of scenarios.  Things can and are manipulated and out there in the world. You can get with a healthy grain of salt. I think not completely discounting.  I do believe that ESG has some value in an investment thesis, but I think not simply taking that as it is, and looking at it in a holistic manner.

Yeah. I almost, I don't know. I like what you said at the beginning there where you said it's more valuable as a management style or a management structure or framework rather than a. Rather than an investing framework. That makes sense to me, because if I'm looking at a company, there might be a better framework that would line up with yes.

I want to make sure that I am choosing a company and supporting a company and owning part of a company that I agree with from an ethical standpoint. And that, and we've talked about this before, like with. The metaverse and Facebook and Mehta platforms, Inc. We've talked about okay, if you're, if you don't like the metaverse idea and you don't want to invest in that.

Okay  don't buy facebook.com, but you have exposure to it if you're in an index fund. So maybe there is some value to the ethical side of it, but that seems like it's a totally different framework than ESG. ESG still seems like a management framework. To me, it seems like maybe it should be called ethical investing, which I think was a term.

And maybe a couple of years ago, and ESG was coming to the light. There was like ethical investing or green investing or something like something along those lines. And I would say, okay, maybe that's a little bit better of a way if you're a financial advisor trying to build a portfolio based on your client's values, or if you're an individual trying to make sure that your investment portfolio lines up with your personal beliefs that's fine.

  And I think that's good. Yeah. That I don't know that ESG is the correct framework. It seems like you would want to look at the company on a case by case scenario and say, okay, does this have your list of qualifications as an investor and go down that list and see if it matches, not necessarily take some third party.

 This is going to be the cynical side of me speaking, but take some third party consultants report on the company and use that as your means of qualifying or disqualifying.  The investment or the the this particular company as part of your portfolio, because the cynical side of me leans towards saying ESG is being hyped because there's money to be made on the reporting and analytics of ESG.

Not that it's actually substantially helpful for the investor and the end user, because if companies are told they must care about. They will pay for consultants and third parties to come in and create ESG reports for them. And that's big money because we're talking about business to business contracts, which are always bigger than B to C products or services.

So that's big money. And so I can see the incentive system there for ESG to become hyped as a investor relations kind of service. But again, I don't know that it's helpful. I think. Jewel investor. If they're consciously choosing stocks, they need to pick that that framework of, okay, these are my qualifications, disqualifications and use that instead of relying on a third party, I think that's a much more clean way to go about it.

And again, you're, you can trust yourself in that because you're to find the information out yourself and qualify or disqualify that company a lot more work. But I think it's probably the better route to go and actually achieve. Rather than tricking yourself into thinking you're actually aligning with your values when really you might not be just exactly what you mentioned with those hedge funds.

 If I was a, if I was a client of those hedge funds, I'd be pissed. If I found out that they had a huge allocation to some company that was completely against my values, because I'd be like, I gave you all this money to invest based on my values. Why didn't you do it well, is it the company's fault?

Is it the hedge funds fault? Oh, yeah, it's probably the hedge funds fault, but is the problem that  they didn't do their due diligence or is the problem they're using the wrong framework entire. So that's my kind of I guess I pushed back against it really being valued at all for, from an investment standpoint.

 But I tend to be cynical.

I'm not surprised that's why I ended up on this particular issue. And I think that, I think. The value to taking a cynical approach, especially when it comes to a and investment hypothesis like this where it's tough because like you said, there's money to be made and  it's a new place to add value and to make value and  it'd be, I think where there is that.

That problem that we've been harping on is that the jump from this is about what this company is doing or planning to do, or et cetera, et cetera, according to these kinds of third-party metrics or maybe a company makes its own ESG metrics. And then just provides that whatever jumping from that to a fund or even an individual investor, et cetera.

 Like we talked about earlier it's difficult to quantify a lot of these things. Certainly there's some situations where companies buying a certain number carbon credits or is hiring a certain number of people from a local areas or different ways that companies try to create metrics around these kinds of ideas.

But it's very difficult to cross reference that because there are multiple different. I said there are multiple different, like zero to 100 ESG scores from different providers. And how do you know which provider is the best of the best? And cause you, then you have to trust a third party about what they're doing to then trust the other parties.

And I actually, I don't know if standard and Poor's has a ESG, but I feel like the standard report is in the Moody's. I'm sure they have ESG ratings and I'm sure that they're probably like the gold standard. So it almost feels like another, almost an augmentation of accredited. Where's the trustworthiness of a company based on ESG but we know where the

last. The big short. Yeah, exactly. Exactly. That's standard and Poor's was for the long and short is basically standard reports was, and Moody's were not accurately rating a mortgage back securities. I hope everything is cool now, but that's my point. Okay. Those risks are financial risks that you can calculate.

Now, clearly you can fudge the numbers on those two, but at least there is somewhere deep in the vault number to back that up. That is exactly correlated to dollar amounts and risk where as with ESG, sometimes that, that can't be fully quantified. Yeah. And so that, that becomes a problem for me. And it's okay how are you?

If this is. Unquantifiable or a very difficult to quantify aspect. And we're trying to put numbers to it. Not only do I have to trust that you put the numbers to it correctly, but then I have to trust that you're accurately putting the formula together correctly and you're not fudging any of the process at all.

And so it's just a, it's a bridge too far for me personally, it doesn't seem like it would add value. I think just going about it, looking at, okay. Do I line up with what this company is? From I immediates maybe it's you look at it from a stakeholder capitalism sort of mentality or a stakeholder   company mentality, where you go, okay what are all the people and entities and situations that this company touches.

And do I agree with the way they're interacting in all these scenarios now that's really, that's a lot of work to put in for each holding, right? So I get. Zero to 100 ESG score. I just, I, again, I don't know that it's that valuable and it might be that perceived value, like it might be all about, which is fair.

 Perceived value is real value, but the perceived value also has to be followed by real value. So for to further explain that, so you can have, let's say out of 10, let's just say there's 10, 10, 0 to 10, right? You could have. I've points of real actual value and then five points of perceived value.

That's fine. But I don't think you can have just straight up 10 points of perceived value because then there's no actual tangible value with what you're with, what you're giving, whether it's a product or a service. So I view ESG as not really having any value at all, even if it does have perceived value.

I don't see that as being real value to the investor. Again, I see it as being a great management system. Yeah. It could impact the long run of the company itself, but from an investment standpoint, trying to qualify the company on that ESG score, I don't really see it having a enough value to warrant.

Okay. That's an interesting point. And I guess, to play a little devil's advocate here  if it's, if it is a best use tool as a management strategy, which I think we both we both believe then is the, almost the correct way of scoring. Perhaps, as as an individual investor, let's say you're not buying into a hedge fund or an ETF or anything like that is the correct way to interpret ESG in your portfolio.

By listening to earnings calls, to reading reports from management and seeing how they're presenting themselves. Because at the end of the day, if you're going to invest in any company and you have to trust their management, and if you trust the management and you're taking them and what they're saying, and the financials are right, and everything, then you can most likely extrapolate that trust.

They're saying any SG. True. Yeah.  That goes back to the governance side of the ESG equation. So maybe out of the two, you can weight the G score more more heavily because if the governance is done correctly, then you could be assured that even   that they're actually following through on what they're saying from the environmental side on the social side.

But if the goal. Is not being accurate, is not being run across the finish line. Then they could just give lip service to the other two. So it makes sense to me. But then again, we're not talking about ESG, we're just pretty much talking about governance at that point, which I think it's, I think that's probably, if you're evaluating individual holdings in your portfolio, I think that's a good way to go about it.

 But I, for one, I'm just, I'm a lazy investor, so I don't

Oh, yeah. I don't really pick individual stocks a lot. I do a little bit, but not a lot. So I view it as I'm letting the indexes do the filtering for me. Now, granted, I'm picking up some stocks that I probably don't agree with ethically, but I, my, my response to that to justify it by justification for that is yes, I'm buying, I'm an owner of that company, but I'm not.

Making the decisions day-to-day that are causing those ethical issues from my standpoint. And also, yes, I'm somewhat funding the company, but I'm not really, if I'm buying it on the secondary market, my funds, my purchase of that security didn't go to fund the company directly. It went to the, whoever I made the trade with.

 So that's my that's my kind of lazy of investing, but. Again, I think there's probably, for me personally, there's more value in focusing on day-to-day tasks that are more meaningful and impactful rather than spending all my time, listening to earnings calls and reading up on the governance of the company.

 You might be better served with the two hours it takes to research to instead pick up trash in your neighborhood or something like that. Again, it comes back to  what's the actual value here? I think it's very hard to pinpoint. And maybe it's different for each person. I don't know.

 Maybe there is a, an argument there that it's so different for each person. Yes. She might make sense. So I don't know. Really. I really don't know where how to answer that question. Is ESG valuable? I don't know. I guess it depends on who you are. Yeah. How has that affect someone's portfolio?

How does that affect

do you think that affects other people. It depends on how much you care to be honest.  It, it could be valuable. I think the valuable or  the value of it depends on how much you care about ESG. If you really care about USG  the underlying components of ESG, then it's probably valuable for you to use it as part of your investment thesis.

If you're actively doing. Stocks because I don't think  I don't think it would really take too much extra time if you're already researching the company or if you're doing, if you're going to financial research on a company and really looking them up and down, then you probably have the time to just glance over the ESG reports on the company.

Maybe look at two different ones to Crawford's cough, reference, cross reference, and a, and you'll be good and move on. But for someone like me, I don't see the value in it. So why use it at all? I use a pretty lazy methodology when it comes to my, the majority of my portfolio.  My thought process is it doesn't affect me.

 So why care too much? I don't, I guess there's my answer to that is how does it affect your portfolio? It affects your portfolio. If you agree with the underlying components of ESG, if not, I wouldn't worry about it. To be honest, if it affects your portfolio, if you want it to affect your book.

honest, honest things you could say about our portfolio because that's not normally very true. I guess from a the reason I don't think it affects long  returns over the long run is because I don't think that there's very good correlation between a good ESG score and actual good a company being a good citizen and taking good actions.

Negative externalities. I don't think there's a F there's very good correlation between the two. Therefore I think it really is more of a a makes the investor feel good, a thing. So I don't think it's going to my personal opinion and you can read all the studies  does it affect returns, but personally, I don't think it really affect returns and knows maybe it would actually hurt returns if you're just qualifying some companies.

If you get a lower return, but you're philosophically aligned with your portfolio and that's important to you. Great. I think it's, I think it's valuable to you. Yeah. And a touching off of that. I think the it's interesting too, to look at a portfolio as not just a tool to make money or not just a tool to make financial goals achievable or achieved, like not just a retirement account.

I think. It's starting to become more of a thought process. And a lot of people is that people aren't necessarily just looking at their 401k or their active portfolio or whatever. They're not just looking at it as I'm trying to make as much money as possible. Now there's always wall street bets

but I think it's becoming more options in your 401k.

I think it's becoming more common to talk to people and hear.  They're actively interested in aligning. They're they're more philosophical and their overarching goals in a little bit closer alignment than just the financial goals. So I think that like we talked about, I think that ratings firms and consulting firms are catching on to that and understanding that and saying, this is a good opportunity, which leads back right back to my cynicism.

not quite as cynical. I will say, I think that there is some real value. But I think that in terms of a portfolio I think, and I'll be transparent about this is that I usually do a moderate amount of research and I'm I'm a individual picker as the opposite of you as well, the two sides of the coin.

 So I do a moderate amount of research into each company. But I can't say that ESG scores factor. Really more than a very small degree. So I think it's, I think, like you said, I think it depends on if you want it to be a factor.  Read, I would say if you're more interested in this stuff, read the reports, read  scholarly papers about core possible correlation between ESG scores and profits.

 Do your due diligence. If you're really interested in this  throw money into a ESG ETF or a hedge fund or something like that. But I think that you have to individually ascertain the value, especially in the long run are you interested in this right now? Just as oh, I'm interested in kind of any ESG stuff or are you interested in that in decades?

Are you saying over the course of my lifetime, I want to be invested in companies that align with my goals, not just financial. Yeah. And I think that's what. Thing the the efficacy of that is something yet to be determined because we, ESG is pretty young. It hasn't been all around for very long, so that  the concepts and underlying arguments behind it have been around for awhile, but actually using it as an investment methodology has not met.

So we'll see.  Maybe we find out over a 50 year period that ESG investing actually leads to reduced returns, or maybe at least to outside. Compared to a benchmark portfolio we'll find out, but  yeah, I think it's on an individual basis. You have to ascertain what's the bad for you from it.

Now a metal play over this is even if you don't think ESG is good for the individual stocks, maybe you think that ESG as a niche is going to grow. And so maybe you want to invest in the ratings agencies or the specific environmental consulting agencies. So we don't really have any, I don't necessarily have any tickers, but maybe.

Agencies consulting environmental consulting. If you find these companies that are the ones doing a lot of ESG research and you think ESG is going to grow as a trend, maybe you don't even necessarily, you're not necessarily worried about it in your portfolio, but you say, Hey, I think that's going to grow.

And I want to make one off of that. Maybe that's a kind of a meta play for ESG investing might be. Yeah that really could be not to be confused with Metta platform thing. Exactly. Totally. But okay we appreciate you entertaining us or excuse me, entertaining our audio this long.

 Usually our episodes go a little bit shorter, but this is a big topic. There's a lot here to talk about. So we, we appreciate you giving us a listen. If you would drop a five star rating on whatever platform you're on, that's very helpful. Feel free to share this with with a friend, if you found it helpful and definitely take a look at our other episodes out there.

Crypto. We talked about Anna NFTs at a certain point as well. And we got really meta with Facebook as well, previous episode. So check those out. This has been the long run show with with Austin Wilson and Michael O'Connor. Thanks for listening.

Support this podcast at — https://redcircle.com/the-long-run-show/donations