Two sides of the same coin

We have over the past few years witnessed high-profile issues that have provided investors with impactful lessons on how poor management of risk in environmental, social and governance can destroy value and reputation. While ESG data aids our understanding of headline-grabbing risks, investors can also enhance it with financial metrics to more robustly evaluate subtle risks and opportunities. 

For example, market research¹ shows rising consumer interest in organic, fresh food products, which could potentially benefit companies that focus on such environment-friendly products. However, fresh food products are more exposed to quality and safety risks and could expose the companies to costly product recalls. Such examples show that ESG data alone sometimes does not illuminate all the risks and potential opportunities. Strong ESG and financial management go hand-in-hand.

So while ESG information often identifies risks which are not apparent in financial statements, investors who give company financials secondary status do so at their own risk. High quality financials – strong cash flow, conservative balance sheets and high return on capital – still matter. We have found that high quality companies have consistently outperformed low quality counterparts in developed and emerging markets. 

We prefer companies that not only deliver high return on capital and substantial cash flow but also demonstrate strong management of ESG risks and opportunities. That’s because quality and ESG represent two dimensions of the same underlying theme: sustainability. Ultimately, a sustainable company is one that produces strong results when measured using traditional financial measures as well as ESG data. 

Although climate change is arguably a longer-term risk, companies that are reliant on fossil fuels need to plan for scenarios in the near term to respond to climate, transition and regulatory risks. Some companies, like Glencore, a global mining major, committed publicly to capping production of thermal coal at 2018 levels. This decision, according to the company, was prompted by its plan to invest in assets that will be more financially resilient to regulation while also addressing the physical and operational risks related to climate change. 

Corporate governance is another example of how ESG issues can affect near and long-term financial performance. A proper board structure, independence of key committees, strong shareholder protections, and executive pay that aligns with performance, are all desirable governance features that investors increasingly demand.

Indeed, one may deduce that a company that is adept at managing ESG risks is likely to skillfully manage other aspects as well, giving it a greater chance of being of high financial quality. This intuitive relationship between quality and ESG is what makes this combination of factors so powerful.

We also believe that positive economic and societal change, and financial performance, is best achieved when ESG analysis is combined with active stewardship. We purposely and actively engage with various entities to promote transparency and raise ESG reporting standards – with companies in which we invest, policymakers and regulators with whom we interact, and our vendors and index providers.

Climate change risk, for example, is a key topic in shareholder activities. It’s difficult for investors to know which companies are most at risk from climate change and which ones are best prepared to mitigate financial and reputational risks as they arise. These assessments rely on clear, concise and consistent data from investee companies as well as research by third parties. 

As a consequence, shareholders have become more and more vocal about the need for companies to increase and improve reporting on climate-related risks to their portfolios. To this end, we aim to target companies and industries that contribute most to greenhouse gases, which trap heat in the atmosphere and cause global warming. In collaboration with other large investors, we are calling for those companies to achieve net zero greenhouse gas emissions by 2050 and to develop clear transition pathways.

All of these tools can be combined into a unified approach in the portfolio construction and management process in order to compose a portfolio that is designed to invest in issuers that exhibit both robust quality and sustainable investing signals, and to encourage them to continue to do so. 

Investors looking to invest at the intersection of profitability and ESG should use a framework focused on a holistic view of sustainability. This approach has historically achieved goals around return, risk and ESG measures that we feel investors may find desirable.

Learn more about integrating ESG data and financial metrics into your portfolio by downloading Northern Trust Asset Management’s latest white paper ‘Investing at the Intersection of Profitability & ESG’. 

¹ Food Market Institute and Information Resources, Inc.