By Graham Campbell

ESG has become the buzz word in investing over the last 12 to 18 months. It seems everyone is talking about it and ever more people are trying to find out about it. Searches for ‘ESG’ and ‘ESG Investing’ have rocketed on Google and numerous ethical funds have been launched to market.

However, ESG (environmental, social and governance) analysis can have its flaws. Like fundamental valuation, ESG ratings can be overblown or understated. We find it surprising that boohoo, a company with severe inherent issues, was rated very highly on ESG before it so spectacularly unwound. Equally, we think it’s remarkable that so many technology businesses score poorly on governance, yet don’t get called out for it.

ESG is not just for niche responsible funds. ESG analysis should be a natural extension to the fundamental research of all portfolio managers. It is an essential guide not just from a moral but an investment viewpoint. It provides another layer of risk analysis that highlights potential problems or solutions within a company that might not be captured in the financial analysis, such as the reputational or brand risk for a business not adhering to social responsibility factors, or governance issues such as nepotism. Another aspect would be the potential negative impact in company culture of not having equal opportunities or a whistle-blower policy, experiencing high staff turnover and so on.

Successful companies tend to set high, but fair standards and fully accept both the economic and moral rationale for implementing ESG targets. When management drag their feet or are unwilling to move forward constructively, they are often hiding other issues which are likely to negatively impact the long-term growth of the business.

A low ESG score or rating in the course of fundamental research should be a potential warning sign that can lead to a fund manager either not purchasing a share or selling a holding where the risks are not appropriately recognised by management.

However, investments based solely on the highest ESG-ranked companies will not always outperform. ESG analysis must be complementary to other fundamental research. A company may not be presently highly ranked in ESG criteria but identifying signs of improvement, which could lead to better operating performance and ultimately a higher rating on the shares, could bring tangible benefit. It is important to maintain a strict valuation discipline in any investment decisions, which includes ESG.

An example of this might be the friendless tobacco sector. Is this not a lost cause in times of ESG? Look a little closer. It is possible to support a change in business culture and a path towards a better company and society, not necessarily the status quo. One example is Philip Morris International (PMI). Its valuation – like the rest of the sector – suffers from the negative impacts smoking has on society. What is not yet reflected in valuation or ESG scores are the structural changes PMI has gone through in the last 10 years which culminated in the launch of IQOS 5 years ago. It is PMI’s “goal to replace cigarettes with the smoke-free products". This reduces the risk to smokers compared to a traditional cigarette and to passive smokers. Overall, the impact on society would be enormous if every smoker moved to IQOS. Although this will not happen, the trend is encouraging. The company has invested heavily over the last 10 years and it is miles ahead of competition. IQOS is not classified as a combustible tobacco product, so taxes are lower. This has a positive impact on margins, ROIC (return on invested capital) and in turn should lead to higher valuation and better returns for our clients. One unquantifiable aspect of the new strategy is the reduced litigation risk for PMI.

Another example is Danone. Danone is already highly ranked for its plant-based dairy business and it is the first listed company to adopt the “Entreprise à Mission” model, which incorporates ESG factors into its articles of association. But its water business has many red flags when it comes to ESG (sustainability of sourcing, packaging, carbon footprint). At the start of the year Danone announced a €2 billion investment programme that will combat all these issues. In the short term, this means a hit to margins. But in the long term, it will set Danone apart from the competition and will increase its brand value and reputation – something that will be reflected in valuation over coming years.

ESG criteria should provide greater depth to the investment debate, to highlight businesses that are embracing environmental, social and regulatory change and flagging the risks surrounding others who prefer a less open and responsible analysis of their actions and behaviour.

Once businesses set targets for emissions, energy usage and the like, management are typically incentivised to meet them. If fund managers can identify such businesses that have the products or knowledge to help them improve their performance, then both parties stand to benefit from their collaboration.

Graham Campbell is deputy chairman of Saracen Fund Managers