Why ESG matters in value investing

As value investors, we have long taken environmental, social and governance (ESG) considerations into account when investing in stocks. After all, it is our job to weigh up risk and reward and we can only do this competently if we consider all of the potential risks around any investment we might make. ESG has clearly become a hot topic in finance at the moment but there are different ways of looking at it.

For example, lots of people tend to focus predominantly on the E, or environmental side, of ESG. When thinking about that, people tend to be drawn to businesses like wind farms or start-ups offering new battery technology.

The problem with this focus on the environmental side is that it often leads you towards small, microcap, new technology businesses. This can introduce some significant, and unwanted, style biases into your portfolios. Instead, we believe it's worthwhile thinking about the whole of ESG in its totality. The E for environment is important, but so is the social (S) and the governance (G) side.

In the social aspect, we think of the stakeholders. These would be the suppliers to the business, the customers, all the staff, and the regulators it deals with. It's every relationship that a company will have with the entire value chain.

These relationships are of crucial importance when thinking about the sustainability of a company’s profit margins, for example. If a business is paying too low a tax rate, or underpaying its staff, or squeezing its suppliers, then fundamental economics suggests that the associated risks increase. So to us, the stakeholders/social part of ESG is an extraordinarily important and all-encompassing risk to consider when thinking about companies to invest in.

The governance side is equally important because it examines how a company is managed. Questions we ask here would be: are there appropriate staff on the board? Are there appropriate checks and balances? Is there an appropriate incentive structure? Ultimately, we need to consider whether the management team is capable of running the business in the best interest of shareholders.

Of course, as active shareholders, these governance questions are an extraordinarily important part of an investment case for us. If we do not believe a company is acting in the interests of long-term shareholders, we will do all we can to actively engage company management to protect and grow our investment.

Thinking about ESG is fundamentally important to all of our investment decisions and it is a theme that fits in with the value style of investing. Ethical investing is often about trying to achieve long-term change. This chimes with our approach, as investors need to take a long-term view in order to access the best possible returns from a value investment style.

Ultimately, value investing is about buying cheap stocks where we think the potential reward is greater than the risks. In analysing the risk part of that trade-off, we will take into account anything that helps us reach the most considered conclusions and ESG is a crucial part of that.