Does ESG Provide A Valid Investment Metric?

There are many, including Blackrock, who claim it does. Is it possible they are wrong? What do you think?

ESG Means What?

ESG is the short form for guidance about how a business performs its environmental, social, and governance goals. A high rating presumes they act positively on each component. Is a high score an indication of greater sustainability?

The problem is finding an objective way to decide how to score the business.

You might notice there are rating agencies and assume that adds value. The assumption might be wrong. Where does the information they use come from, and how deep do they drill to get it? Then how do they assign meaning? I think for investing, the key is assigning meaning to information. It is not an idiot-proof task.

There are problems

These ones are obvious.

The ESG scores tend to be out of context. A software company where all the engineers and programmers work from home produces minimal CO2. Should they have a higher score than one where the people work in a single building? YOu would need some data on energy consumption from hundreds of locations compared to one big one. Do a thousand home air conditioners use the same energy as one that serves 1,000 employees? I don’t know, but I am suspicious that scale improves efficiency.

Social matters. Does hiring based on gender, ethnicity, or race improve the business? It might if you believe diversity adds value. Other than scholarly opinion, I can’t find much objective evidence on the subject. There are many social factors.

Governance is very nebulous. To me, governance is about who makes important decisions. Henry Ford produced an interesting analogy with his answer to the question, “Who should fly the plane?” He thought it best if the plane was flown by someone who knew how. But then he was an old, white guy who valued competence above other values. That seems not so important today.

Where does it lead?

As an investor, you should use metrics that relate to your personal motives for investing. If you are investing in providing money for living costs in retirement, you might prefer measurable factors. Things that have proven to indicate income potential and growth over a long time. Retirement income is essential. Why would you pay any attention to metrics that have no provable connection to investment performance?

Be careful with business objectives that include things unrelated to business success. You should question what sustainable means. It is a contextual thing. Does it mean the business will tend to flourish in conventional terms, or does it suggest that government and activist action will make otherwise profitable firms less able to continue? If a highly profitable company goes out of business and is replaced by one barely earning enough cash to support its market share, would you be better off holding shares in the survivor? Thank you, NO!

If you are investing money you don’t need, investing in companies with a high ESG score might be acceptable. If you are looking for investment performance, the Wall Street Journal recently published material that suggests you would be better off buying ones with low ESG scores. The unproven assumption is they are sticking to business things and leaving the woke to fend for themselves.

What you should notice.

Competent managers pay attention to the environment, social ideas, and governance. They recognize them as parts of their business context and will do what they can to enhance their fit and thus improve their profitability and growth potential. It is about priorities. Should the focus be business or ESG factors that no one can or does measure?

For many businesses, ESG is a form of virtue signalling. Worse yet, it is a way to signal allegiance to the ideas of the woke leftists. It is not impossible that you can be hurt by woke activists, but if you only play defence, you will forget why you are there.

It’s a phase like ethical investing a few years ago. When it provided no measurable value, people gave up on it.

What you should do.

Decide why you are investing, and then decide how much more you must invest to be able to accept lower returns on your investments and get the answer you need. That difference and all the income it might have earned is your commitment to supporting ESG.

Why do that? Simple really. People make better decisions when they look at both the expected benefit and the cost to get it. No benefit comes without a cost, and some very weak choices are made without information. ESG is fuzzy on the value of its purported benefits and totally obscure on the cost of achieving those.

 Let’s agree on some things.

Everyone prefers a clean, enduring environment offer a fragile and dirty one.

Every ethical person does not stand in the way of another person’s advancement.

Every intelligent business executive tries to optimize the mix of business resources to provide good products and services at a fair price.

Business is hard enough without distractions that add no value for anyone.

ESG denies the value of specialization. One business trying to do everything provides less value to an investor in a specialist business. The investor can then use the excess to accomplish other tasks.

All your stock analysis should include ethics. Ask yourself about profits achieved at great cost to others. Does child labour matter to you? Probably. Should you apply North American standards to less developed countries? Would you think differently if a 12-year-old had to work or his family starved? I know that is a hard call, but it is real life. Don’t overdose on ethical standards that aren’t universal.

Don’t pay much attention to journalists and commentators who have not been there and done that. Utopian ideas and talk are both inexpensive. Doing is another form of activity entirely.

The bit to take away.

Investing based on fuzzy metrics costs money that might better be donated to a charity that acts on real problems.

Do you think Charlie Munger and Warren Buffett pay attention to ESG metrics?

I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

2 Comments on “Does ESG Provide A Valid Investment Metric?

  1. Sounds like a wonderful opportunity for financial string-pulling and manipulation.Sent from my Galaxy

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