Matthew Griffith, CFA, Senior Research Analyst & Brent Williams, CFA, Senior Research Analyst
You may have heard of ESG investing, but what is it really? ESG investing focuses on identifying companies that have strong Environmental, Social, and Governance ratings. While the Environmental component of ESG is often clear and easy to understand for individual investors (think greenhouse gas emissions, pollution, and usage of recyclables and renewable energy), the factors considered for Social and Governance ratings can be less obvious. The second part of our Perspectives series on ESG investing focuses on the “G.”
As defined by Sustainalytics, a firm focused solely on providing ESG research on publicly-traded companies, Governance analysis is an evaluation of how well a company is structured and managed in order to “build sustainable, long-term value that can be delivered to shareholders and other stakeholders in a fair and transparent manner.” To build long-term value, quality leadership is critical, at both the day-to-day management level (e.g., CEO and other executives) and on the board of directors, which appoints and oversees management. How these leaders are compensated can have a major impact on the decisions they make when running a company, and therefore a well-developed compensation plan is critical to incentivize the right goals. A company with high Governance ratings may reward its leadership team more for progress on an internal growth project than it would for quarterly earnings growth or stock price increases. Managing solely to either of these short-term goals is often unsustainable. Another best practice that is becoming more common is linking a portion of compensation to measurable progress on meeting sustainability goals.
Board diversity and independence are typically characteristics of a company with high marks for Governance. To best position for long-term sustainable success and evaluate all opportunities and threats, a company’s board should be composed of people with a variety of personal and professional backgrounds. To provide a level of checks and balances, a majority of board members should be independent from a company’s management team and, ideally, a company’s audit committee should be composed entirely of independent board members.
Accountability and transparency are important to ensure that company success is achieved in the right way. Companies with high Governance ratings typically follow strict anti-bribery and anti-corruption policies, and offer protection and support to internal “whistleblowers” who identify problems within a company. While having well-developed policies and procedures in place is important, a clean operating record without a history of major controversies in these areas is also a major consideration.
An increased focus on ESG investing is pushing companies to be more attentive to how they impact the world around them. By factoring ESG into portfolio construction, an individual investor has the ability to direct his or her investments towards companies that strive for excellence and push their industry peers to improve as well.
Part one of this Perspectives series about the “S” in ESG investing can be found here. For more information, contact your D.A. Davidson financial advisor.
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