ESG has become an established part of the investment landscape, but Tobias Bucks, co-manager of the IFSL Marlborough Global SmallCap Fund, argues that meaningful ESG analysis requires looking beyond corporate messaging and understanding the underlying quality of individual businesses.
An interesting debate has been playing out in investment circles during the past few months. It centres on whether ESG is in the midst of a sensational comeback or is only now really starting to find its feet.
Naturally, the truth may well lie somewhere between the two. Whether you’re tempted to lean this way or that is likely to depend largely on how you’ve regarded ESG since it entered the mainstream 20 or so years ago.
On the one hand, let’s say you’ve seen it as a bit of a fad and as a box that glossy, fulsome reports and carefully crafted corporate pledges are sufficient to tick. The “comeback” option is probably for you.
On the other hand, let’s say you’ve viewed it as a transformative development that has somehow failed to fulfil its game-changing potential. You’re more likely a disciple of the “starting to find its feet” school of thought.
And me? I’m very much in the latter camp. I firmly believe ESG is an essential component of investment decisions – and I also believe it has all too frequently been treated as anything but.
So what would it take for ESG not only to really start finding its feet but to genuinely plant them in the wider investment landscape? In my opinion, there are two issues that merit much more awareness.
The first is the risk of index-tracking funds exposing investors to companies that have poor ESG characteristics. Even some of the world’s biggest and most successful companies can disappoint in this respect.
The second is the enormous importance of ESG at the proprietary level. This is where active management and direct engagement can be a difference-maker, not least in the arena of smaller companies.
Beyond window dressing
The pros and cons of conducting in-depth research into a business are, of course, the subject of another debate in investment circles. So are those of meeting with a company’s representatives. The arguments are pretty well-worn.
Let’s begin with the case against. To summarise: the opponents of active management and direct engagement insist there’s nothing to be gained from such an approach, especially in an era of increasing disclosure demands and AI-driven data analysis.
They may have a point. After all, recent history has shown it’s possible to earn a decent return from passive funds that are heavily weighted towards a handful of household-name companies with trillion-dollar market valuations.
Yet what do many passive investors actually know about these holdings? More specifically, assuming they care about such matters, what do they actually know about these holdings’ ESG credentials?
The answer, more often than not, is next to nothing. If anything, they’re likely to know only what the companies want them to know.
For example, a business might proclaim it’s doing its best not to contribute to global warming. It might trumpet its commitment to boardroom diversity. It might boast that its employees delightedly go litter-picking once a month.
This is the sort of stuff that routinely occupies countless column inches in corporate social responsibility (CSR) brochures and the like. It has in many ways become an industry in itself.
I’m not suggesting none of this matters. There’s plenty to be said for staving off climate change, encouraging myriad worldviews and keeping the streets clean. But even today, more than two decades after the term “ESG” earned a place in the investment lexicon, much of this is mere window dressing.
Looking for a genuine ESG edge
To get an accurate sense of a business’s ESG credentials, in my view, it’s vital to dig deeper and discover what really counts. This requires not only more quantitative data but also the introduction of qualitative insights.
Why is this particularly significant for smaller companies? Unlike their more sizeable counterparts, many of these stocks attract little or no attention from the investment analyst community.
This constitutes a curious oversight, given that, historically, small-caps and mid-caps have tended to outperform large-caps and mega-caps over the long term. It’s why an actively managed fund like ours relies both on its own research and, crucially, on its direct engagement with businesses around the world.
I mentioned earlier the importance of ESG at the proprietary level. This means getting to the bottom of ESG commitments that clearly relate to an individual company – rather than settling for those that merely deal in the usual tropes for the purposes of padding out a cookie-cutter CSR round-up.
Take one of our top holdings, Powell Industries. A US-based electrical engineering and manufacturing company, it’s a niche leader in switchgear and control systems. We see it as a classic “picks-and-shovels” play on the AI build-out.
From an ESG perspective, we admire Powell’s focus on appropriate areas of human capital and safety. Its workforce management and employee-related initiatives score notably highly in our analysis, giving it an edge over its peers.
There’s still room for improvement. There invariably is. As shareholders, we’re entitled to highlight as much. As a company for which ESG is more than an empty buzz-phrase, Powell is happy to listen.
Ultimately, ESG is a fad or a box-ticking exercise only if we render it as such. This is as true today as it was 20-odd years ago. Whether in the sphere of smaller companies or elsewhere, our collective task is to recognise – and to maximise – its role as a powerful driver of long-term returns.
Main image: ESG, light bulb, idea, riccardo-annandale-7e2pe9wjL9M-unsplash
