What Is ESG Investing?

There are a variety of different investing philosophies within the socially responsible investing (SRI) realm. One method you may have been hearing about more and more is ESG investing.

The letters "ESG" stand for environmental, social, and governance. Investors who employ this strategy examine criteria within these three categories to analyze stocks. Combining the ESG lens with more traditional stock analysis techniques is known as ESG integration. Anyone can join the swelling ranks of ESG investors by simply learning more and then using this framework in making future investing decisions.

It's no wonder ESG investing is gaining traction. Research is increasingly showing that this investing method can reduce portfolio risk, generate competitive investment returns, and help investors feel good about the stocks they own.

What is ESG?

First, let's demystify the ESG acronym to highlight what ESG investors look for when seeking stocks to analyze. ESG investing entails researching and factoring in environmental, social, and governance issues, in addition to the usual financials, when evaluating potential stocks for your portfolio.

E is for environmental

The environmental component requires research into a variety of elements that illustrate a company's impact on the Earth, in both positive and negative ways. A company that's an actively good steward for the environment might be deserving of your dollars.

Environmental topics to research and analyze include:

Climate change policies, plans, and disclosures.
Greenhouse gas emissions goals, and transparency into how the company is meeting those goals.
Carbon footprint and carbon intensity (pollution and emissions).
Water-related issues and goals, such as usage, conservation, overfishing, and waste disposal.
Usage of renewable energy including wind and solar.
Recycling and safe disposal practices.
Green products, technologies, and infrastructure.
Environmental benefits for employees such as cycling programs and environmental-based incentives.
Relationship and past history with the U.S. Environmental Protection Agency (EPA) and other environmental regulatory bodies.

For those details, locate sustainability reports prepared using respected sustainability standards such as Global Reporting Initiative (GRI) and Principles for Responsible Investment (PRI). Corporate websites with sustainability pages can be useful for budding ESG investors, but be wary when they don't contain enough detail to paint a complete picture. For example, we can appreciate companies that demonstrate a commitment to recycling, but that alone would not merit a check in the "E" category. Note how the word "goal" is sprinkled throughout the above bullet points. While goals are nice, concrete numbers and metrics that demonstrate real progress are much better.

Nike (NYSE: NKE) is a company that meets the environmental criteria of ESG. A leader in environmental dedication, Nike has a chief sustainability officer that oversees its many environmental efforts. Its Flyknit and Flyleather products were developed with environmental sustainability in mind. Nike signed onto a coalition of companies called RE100, vowing to source 100% renewable energy across its operations by 2025. There's more, but any interested investors should read Nike's latest sustainability report, which uses the GRI framework, the Sustainability Accounting Standards Board (SASB), and the United Nations' Sustainable Development Goals (SDG) -- all great examples of the valuable data that ESG investors should look for.

S is for social

The social component consists of people-related elements like company culture and issues that impact employees, customers, consumers, and suppliers -- both within the company and in greater society.

For information on social aspects, ESG investors should look to sustainability reports that use a respected standard like GRI or PRI, because those sustainability reports go beyond environmental issues to include information on employee, supplier, and community elements, too.

It's also useful for ESG-minded investors to keep up with respected lists and annual rankings, including Fortune's Best Companies to Work For and Forbes' Just 100. Pay attention to media reports related to how companies treat their employees and their lobbying efforts for or against social justice issues. Another really good place to gauge how a company and its management is received by its workers is employee review website Glassdoor.com.

Social topics to research and analyze include:

Employee treatment, pay, benefits, and perks.
Employee engagement and staff turnover/churn.
Employee training and development.
Employee safety policies including sexual harassment prevention.
Diversity and inclusion in hiring and in awarding advancement opportunities and raises.
Ethical supply chain sourcing, such as conflict-free minerals and responsibly sourced food and coffee.
Mission or higher purpose of the business (or lack thereof).
Consumer friendliness, customer service responsiveness, and history of consumer protection issues including lawsuits, recalls, and regulatory penalties.
Public stance on social justice issues, as well as lobbying efforts.

Accenture (NYSE: ACN) has an admirable workplace approach, earning it a spot on Fortune's list of Best Companies to Work For for 11 years. Accenture pays close attention to its diversity and inclusion in its workforce. The company plans to improve its workplace gender ratios, with a goal to have 50% female and 50% male employees by the end of 2025. Accenture plans to better its corporate makeup as well, pledging to have at least 25% female managing directors by 2020. If you crack open Accenture's Corporate Citizenship Report, you will find that its efforts satisfy some of the UN's SDG framework, and the report also uses the GRI disclosure standard.

G is for corporate governance

The corporate governance component relates to the board of directors and company oversight, as well as shareholder-friendly versus management-centric attitude. In less dry terms, ESG investors analyze how corporate managements and boards relate to different stakeholders, how the business is run, and whether the corporate incentives align with the business's success.

Corporate governance issues come up every year during proxy season, when most companies file their proxy statements announcing their annual meetings. These documents cover a variety of corporate governance topics. Shareholders vote on a variety of issues presented to them annually, such as executive compensation ("say-on-pay"), director appointments, and shareholder proposals.)

Governance topics to research and analyze include:

Executive compensation, bonuses, and perks.
Compensation tied to metrics that drive long-term business value, not short-term EPS growth.
Whether executives are entitled to golden parachutes (huge bonuses upon exit).
Diversity of the board of directors and management team.
Board of director composition regarding independence and interlocking directorates -- which can indicate conflicts of interest.
Proxy access.
Whether a company has a classified board of directors.
Whether chairman and CEO roles are separate.
Majority vs. plurality voting for directors.
Dual- or multiple-class stock structures.
Transparency in communicating with shareholders, and history of lawsuits brought by shareholders.
Relationship and history with the U.S. Securities and Exchange Commission (SEC) and other regulatory bodies.

Intuit (NASDAQ: INTU) satisfies many of the attributes in the corporate governance category. It has achieved a 40% diverse board, one of the highest levels in corporate America today.

Strong management teams and boards have a significant amount of "skin in the game," meaning they own shares of the stock they're steering and a personal incentive to make the company perform well. Intuit displays this with strong stock ownership guidelines that dictate Intuit's CEO must hold stock worth 10 times their annual salary, and non-employee directors must hold the equivalent of 10 times their annual cash retainers. Intuit shows accountability by tying its executives' incentive compensation to revenue and non-GAAP (Generally Accepted Accounting Principles) operating income, as well as to the company's overall performance on annual goals related to employees, customers, partners, and stockholders.

Many corporate governance details are found in the sustainability reports, but interested investors should also read the annual proxy statements they receive from companies they own shares of. To research corporate governance attributes (including interesting tidbits such as CEO pay) before buying a stock, you can access proxy statements on the SEC's website by searching for the filing type DEF 14A.

The history of ESG investing

Over the course of decades, many management teams and investors have adhered to the shareholder value theory, which was popularized in 1970 by Milton Friedman (and is also known as the Friedman Doctrine). Friedman argued that companies' only social responsibility is to maximize shareholder value, in effect to make money for the folks holding the stock.

Proponents of shareholder value maximization put the pursuit of profit (and shareholder returns) above all other considerations. Pursuing profit isn't inherently dangerous -- after all, lack of profits can lead to a host of bad outcomes for companies including bankruptcy. But many businesses can run into serious problems if management is only concerned with maximizing short-term profit measures to please Wall Street, at the expense of all other stakeholders. Companies that chase the approval of the markets instead of building relationships with employees can end up making workers more likely to unionize or quit. And when this toxic philosophy pervades a company's culture, it's more likely that employees will make the poor decision to engage in dangerous, risky, or even illegal dealings to appease management's demands for short-term profit. Ultimately, obsessing over EPS and other short-term metrics is a good way for companies to open themselves up to lawsuits, investigations, and regulations.

Enter: Socially responsible investing (SRI), which sprung from a niche investment strategy that emerged in the 1960s and '70s, around the same time as Friedman's statement. Some consider the Quakers' earlier exclusion of "sinful" companies as the significant root of this philosophy, but many other observers point to South Africa's apartheid period as a crucial tipping point, when investors began divesting from companies that did business there based on moral and ethical grounds.

For decades, shareholder value theory has been protected by the hefty returns enjoyed by investors, but modern investors are increasingly realizing that shortchanging stakeholders to juice shareholder returns is too high a price for society to pay. A company's stakeholders go way beyond shareholders to include its employees, customers, suppliers, distributors, communities, neighbors, and the environment. And in an ironic twist of the shareholder value theory -- shoddy treatment of stakeholders presents financial risk, as shareholders have the power to damage the company by selling their shares. This collective realization helps explain why SRI and other ethically focused investing techniques have grown in popularity and coverage.

Investment strategies related to ESG

SRI generally uses exclusionary screens, or filters, that investors can use to exclude certain companies and industries that don't meet their particular value criteria. The SRI investor sets their screen to make an investment decision by tailoring it to their own values. For example, many SRI investors screen out tobacco, alcohol, and weapons stocks, leaving most other companies and industries eligible to select for further analysis. Others take issue with lobbying done by certain companies, and keep them out of their consideration pool for that reason. SRI investors might also screen out all companies in a particular industry except those considered "best in class." A best-in-class investor might screen out all fossil fuel companies except those that outperform their peers in the areas of sustainability, employee treatment, and corporate governance.

Shareholder activism is another form of SRI investing, in which investors buy shares of companies that other SRI investors find unpalatable or reprehensible, with the expressed purpose of engaging with those companies to encourage, or demand, improvement. Engagement tactics include filing shareholder proposals, attending annual meetings, and speaking directly with executives. This strategy isn't necessarily about making money or being long-term buy-and-hold investors. Usually, these shareholders sell their shares after companies adequately engage with them on reform by addressing the targeted issues or even fully meeting their demands.

Unfortunately, not all activist investors are socially responsible. The other type of shareholder activist typically buys large stakes in companies to influence management, but they hail from the shareholder profit camp, pushing for short-term profit boosts that can damage long-term strategic initiatives. It only works because of the massive amount of money they sank into the company, so becoming an activist investor isn't an option for most individual investors anyway. But it's worth knowing about these deep-pocketed vultures, so you can raise a red flag if one of your investments gets targeted by one.

Impact investing is another philosophy under the SRI umbrella. Impact investors put their money in companies that have demonstrably positive environmental and social impacts, on top of positive financial returns. Impact investors have differing expectations when it comes to financial returns. While some target below-market-rate returns, others expect results that are comparable or even beat the market, according to the Global Impact Investing Network. An impact investor may make an investment where the measurable outcome relates to a highly impactful area, such as boosting sustainable agriculture. Therefore, a financial outcome that matches or beats the return of the S&P 500 isn't what they measure to gauge success. Rather, they aim to see progress in their desired area, by tracking the indicative metrics they identified before buying the stock.

Conscious capitalism is another buzzword you've probably heard. It's a business management strategy that emphasizes aligning the business with stakeholders for shared success. A company that fits within that realm not only seeks profits to benefit shareholders, but also serves other stakeholders like employees, the environment, suppliers, customers, and communities. Serving all stakeholders is thought to strengthen a business and generate long-term profitability. The focus on creating value for stakeholders puts conscious capitalism in the same philosophical category as SRI or ESG, but it's better understood as something that should be embodied by an executive. Investors can look to conscious capitalism as a way to think about management of the companies they own, but it's not an investing discipline per se.

How ESG investing is different

ESG is most like SRI in that it focuses on investing in publicly traded companies. However, ESG investors actively opt in to companies because of impressive environmental, social, and governance attributes they've demonstrated. Conversely, a traditional SRI investor focuses on excluding certain industries or companies because they have failed in certain aspects. ESG can be confusing for folks who are more familiar with the straightforward SRI approach. But just remember that with SRI, your beliefs demand you outright exclude whatever sectors you loathe, whether that's tobacco, alcohol, weapons, gambling, or other sin stocks. ESG offers more flexibility and depth of research into the nuts, bolts, and fine details that make up a comprehensive corporate initiative and define management's patterns.

Sometimes, ESG homes in on companies' material issues, which depend on their industry. SASB designed a Materiality Map to illustrate what defines financially material issues -- things that are "reasonably likely to impact the financial condition or operating performance of a company and therefore are most important to investors."

An issue that's financially material for one industry may not be material for another. It's fabulous when companies donate money to noble causes, but charitable giving doesn't typically impact operations beyond good PR and brand enhancement. For ESG investors, charitable giving is not usually a financially material aspect to consider. But climate change, along with its causes and effects, is a financially material issue, as global warming will substantially impact every company everywhere. Data security is of utmost importance to internet companies and retailers, but less material for infrastructure companies. SASB's Materiality Map offers tips on how to navigate these differences.

Just because an issue isn't financially material to a company doesn't mean it doesn't matter to investors. There will be occasions when a socially responsible investor will buy or sell on the grounds that it's the right thing to do, regardless of the issue's direct financial impact.

ESG can yield interesting results that may not always feel comfortable, especially to traditional socially responsible investors, due to its novel combination of an inclusionary criteria and financial materiality clause.

A distasteful industry can yield a high-ESG company. For example, a defense company that specializes in missile production and scores high on environmental sustainability, employee treatment, corporate governance, and diversity may merit inclusion in an ESG fund, even though it would be a "no-fly zone" stock for a traditional SRI investor.

Some ESG investors do screen out entire industries, excluding certain companies no matter how high they rank in ESG areas. Bear in mind that throughout the financial industry, ESG is used in different ways, and there are no official standards yet. This is one reason you may occasionally see news articles arguing that some purported "socially responsible" products actually aren't.

If you're not a self-directed investor, it's important to do your homework on the methods your money manager uses, and whether they screen out certain industries. Otherwise, you may find a company from an industry you don't feel good about in your portfolio.

When rationalizing ESG investing with the greater SRI industry, it's important to remember that ESG is also a stakeholder-centric theory, which argues how companies treat all their stakeholders will impact their long-term success or failure.

How ESG investing can reduce risk

Beyond its ability to help uncover attractive long-term investment opportunities, ESG has experienced a great deal of traction within the financial world thanks to its role in reducing risk. Stakeholder treatment issues including climate change and resource scarcity pose serious risks to all companies' operations and profits. To see how integrating ESG can help investors mitigate risk, here are few examples of risky corporate behavior where employing ESG could have helped.

Environmental risks go further than the usual regulatory and reputational risks. Environmental challenges cause a variety of issues and global warming is on track to devastate entire economies if it's not mitigated or reversed. Other implications of climate change are resource scarcity, more frequent natural disasters of greater magnitude, and increased global poverty, as well as political unrest, instability, and even war.

In a recent worst-case scenario, PG&E (NYSE: PCG) became the first company to suffer a hefty blow partly due to climate change-induced conditions that caused enormous wildfires. PG&E declared bankruptcy, an extreme outcome that is likely to become more common if companies don't adequately prepare for risks related to climate change -- or better yet, actively work and invest to improve the outlook of global warming.

What about worker treatment? It stands to reason that unhappy, unhealthy, or stressed employees won't be eager brand ambassadors, willing to provide excellent customer service, or dream up innovative new ideas for the company. They're also more likely to quit their jobs, leading to high employee turnover that forces the company to spend more money on hiring, training, and onboarding new employees. Research shows treating employees well -- and keeping them engaged with their work -- helps business operations. Companies that excel at engaging their employees achieve per-share earnings growth more than four times higher than rivals, according to Gallup. Compared with the companies in the bottom quartile, those in the top quartile when it comes to engagement generate higher customer engagement, higher productivity, better retention, fewer accidents, and 21% higher profitability.

Diversity pays, too. Companies with low levels of gender, racial, and other forms of diversity across workforces, management teams, and boardrooms lose out on intellectual capital and valuable perspectives. Research shows that teams composed of the exact same types of people make worse decisions and fare worse financially, too. In 2018, McKinsey examined data from 366 public companies in the U.S., Canada, Latin America, and the U.K. and found companies in the top quartile for gender, racial, or ethnic diversity are more likely to generate financial returns above the national medians for their industry. The converse was also true. McKinsey concluded that "diversity is probably a competitive differentiator that shifts market share toward more diverse companies over time."

High ESG, high returns

Risk reduction is important, but many more people are coming around to the notion that strong ESG traits can be viewed as indicators of companies with exemplary management teams. After all, concern about ESG factors goes hand in hand with long-term thinking, and the ability to consider far-out outcomes demonstrates a clear vision. Strategizing and planning decades in the future is a necessary shift in the business world, where too many CEOs chase short-term, quarterly profits. Thinking about how a business impacts various stakeholders requires a level of holistic, creative thinking that shouldn't be underestimated as a competitive advantage.

Former PepsiCo (NASDAQ: PEP) CEO Indra Nooyi sagely envisioned that trends would shift to healthier offerings (and unhealthy snacks and drinks contribute to public health risks, too, a factor that would be significant to ESG investors), and so she began dedicating research and development spending to devise healthier treats that appeal to consumers.

Integrating ESG into business operations allows executives to better manage complexity, too. Just think of how difficult it is to change the operations of a massive, legacy business -- and plenty of executive management teams are doing it. In one encouraging sign, 85% of S&P 500 companies now publish detailed sustainability reports outlining their efforts, up from 20% in 2011.

Plenty of data backs up the notion that high-ESG companies are also well-run, ultimately producing financial results comparable or superior to their low-ESG peers. Fortune cited data from asset management start-up Arabesque that found that S&P 500 companies in the top quintile in terms of ESG attributes outperformed those in the bottom quintile by more than 25 percentage points between the beginning of 2014 and the end of 2018. The high-ESG companies' stock prices were also less volatile.

Consider this conclusion from The Journal of Applied Corporate Finance by Dan Hanson and Rohan Dhanuka:

Stunning growth in ESG

Ethical investing has come a long way since SRI was a small niche in the investing universe. SRI, ESG, and impact investing used to not even exist, and now they're catching on with both financial institutions and everyday investors, all of whom are seeking to do good with their investing dollars while doing well for themselves.

According to US SIF's 2018 Report on Sustainable, Responsible, and Impact Investing Trends, total SRI assets jumped 38% to $12 trillion since 2016 in the U.S. alone. These assets represent 26% of the total U.S. assets under management ($1 in $4). For perspective, when US SIF first measured the size of the market in 1995, it was $639 billion; the area has increased 18-fold, and has since enjoyed a compound annual growth rate of 13.6%.

There are a variety of reasons why this style of investing is becoming more mainstream. A frequently cited reason is that millennials consistently show a tendency to crave social responsibility, whether it's in the products they purchase, the organizations they work for, or their investment portfolios.

This activist attitude has been reshaping many aspects of how business works in our society, including companies' increasing willingness to incorporate ESG strategies into their business models and taking public stands on issues that were once considered too controversial. Why? Millennials are a massive generation, comprised of at least 71 million individuals who were born between 1981 and 1996 in America alone. Millennials represent $600 billion in annual spending in the U.S., a figure expected to grow to $1.4 trillion annually by 2020, according to Accenture.

Baby boomers -- another huge demographic -- are poised to pass their money down to future generations, with an unprecedented $30 trillion expected to come under new stewardship over the course of the next several decades.

Big financial institutions haven't missed this detail about a key demographic. Morgan Stanley's Institute for Sustainable Investing conducted many studies and surveys related to the link between millennials and sustainable investing. In 2017, its survey of active individual investors revealed that (emphasis original) "86% of Millennials are interested in sustainable investing, or investing in companies or funds that aim to generate market-rate financial returns, while pursuing positive social and/or environmental impact. Millennials are twice as likely as the overall investor population to invest in companies targeting social or environmental goals. And 90% of them say they want sustainable investing as an option within their 401(k) plans." Bank of America Merrill Lynch predicted that in the next 20 to 30 years, millennials could pour between $15 trillion and $20 trillion into ESG investments in the U.S.

Risks of ESG investing

Every investing strategy has risks, and ESG is no different. Let's go through a few potential pitfalls of this approach and how you can avoid them.

One of the major ongoing risks is the lack of standards in the fledgling industry. While this opens the playing field for many interesting approaches to doing good while generating a solid investment performance, it also increases the possibility that some ESG investment firms will exploit this area for marketing, rather than employing disciplined ESG investment strategies.

The growing ranks of ESG investors as well as huge financial institutions moving into the ESG arena is a validating sign. There's added potential for better data on ESG performance, but that data may show that individual ESG investors aren't the rockstars we'd hoped them to be over the long term. Headlines from new research studying more ESG investors may tout that "ESG doesn't work" -- which may be true, for some investors. After all, not everyone is a great analyst or stock picker (across all investments, not just ESG). Fortunately, younger people don't mind underperformance to the same degree as older folks. Surveys of millennials consistently show they accept lower performance in order to invest in highly sustainable companies. So even if millennials underperform, they're sleeping better at night.

Younger people are moving into investment firms to perform research and analysis, and it's reasonable to assume many will hone in on ESG. Most millennials have yet to weather a major economic downturn before and so their investment strategy remains untested. In the event that we see a recession, ESG-related sectors could take a significant hit -- especially if younger investors bail on their ESG investment theses under pressure.

Another risk is if companies were to abandon their attempts to become more stakeholder-centric, and stop reporting sustainability data. Any broader move away from enhancing ESG attributes would make it hard for ESG investors to find high ESG companies to invest in.

Is ESG right for you?

Hopefully ESG investing has been somewhat demystified for you now -- or, if you were already aware of it, perhaps your enthusiasm for the investing philosophy has been stoked further or renewed. If you're attracted to socially responsible investing, and you want your portfolio to outperform the broader market, ESG investing could be a great match for you.

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Alyce Lomax owns shares of Nike. John Rotonti owns shares of Accenture. The Motley Fool owns shares of and recommends Intuit and Nike. The Motley Fool owns shares of PepsiCo, Inc. The Motley Fool recommends Accenture. The Motley Fool has a disclosure policy.