Thinking Outside of the Box

derailed-tracksYou can’t mitigate investment risks that you don’t understand — which is why it’s more important than ever to analyze equities through an environmental, social and governance (ESG) lens. So says Ross McSkimming, investment director, equities, with Standard Life Investments.

“You need to look at ESG issues in detail when reviewing companies,” he explains, adding that such factors can help identify opportunities, not just risks. Consider electric cars to reduce carbon and address climate change issues. While the opportunities are important, the risks are even more prevalent, McSkimming said; they should be front and centre for analysts. A company’s exposure to risks related to ESG can derail its performance and even its business model, whether the risk is pollution, human rights violations or board remuneration.

He cites the example of Sports Direct, a U.K.- based company that ended up dominating headlines because it mistreated staff. Bad news like this affects a company’s share price and creates major problems for the brand itself. In the high-profile case of Starbucks, a tax evasion scandal in the U.K. caused some customers to boycott its products.

Bad behaviour on the part of companies is a big risk for investors, who should be highly skilled in understanding and identifying what the risks are, right alongside traditional factors like sales growth, margin, cash flow and market share valuation.

“We have a responsibility to investors to invest in the long-term capital of these companies,” explains McSkimming. “We need to make sure we make the right choices.”

The big question for plan sponsors and portfolio managers, however: How to integrate ESG into the investment process?

One key step is ensuring that analysts and portfolio managers are looking at these issues in the first place. ESG should sit alongside traditional measures as a means of understanding a company’s potential and performance.

Plan sponsors should also seek full transparency, says McSkimming, adding that “an environment that openly encourages discussion and debate” should be part of the foundation of any investment process.

A dashboard for ESG risks could also be a helpful tool — and it can help investors understand whether performance is coming from ESG factors. McSkimming encourages plan sponsors to look at how research is shared and how risks are monitored. And he cautions plan sponsors against putting their ESG analysts into a “box” — they should instead be integrated with the rest of the team.

“You don’t need to sacrifice returns when supporting the groundwork for a better world,” he says. “But still, many investors are failing to integrate ESG into their approaches.”

That could be because of divergent opinions about what ESG means — or the misguided belief that ESG means lowering return expectations.

In the end, McSkimming finds a quote from Mark Twain helpful in explaining the long-term importance of ESG: “Plan for the future because that’s where you are going to spend the rest of your life.”