How to Move ESG from Philosophy to Alpha Generator
Many investors are privately more fervent proponents of environmental, social, and governance (ESG) philosophy than they are in public. Conventional wisdom holds that the investment pro’s job is to make investors money, and besides, investing in ESG is a sure way to lose alpha. But the world and commerce are rapidly changing, providing alpha opportunities for the informed and prepared.
Steven Soranno, CFA, CAIA, is a senior analyst with Calvert Investments, where he designed the process for incorporating ESG information into equity valuation models and investment theses. He has written extensive, globally published investment research, and has also teamed with globally ranked executives and consultants on thought-leadership pieces regarding innovation, digital economics, and security valuation. Here is an interview in which Soranno talks about how to move ESG from philosophy to alpha generator.
Jason A. Voss, CFA: I know that you believe environmental, social, and governance (ESG) philosophy is a source of alpha. To many that is probably a surprising claim. Tell us more about why you think this is true.
Steven V. Soranno, CFA, CAIA: As long as it remains surprising, there should be good alpha generation headroom. Changes to the global economic paradigm alter the way value is created — always have. The paradigm has evolved substantially in the past 20-ish years, so the way we identify and measure value must therefore evolve. The types of information we look at and how we process that information needs to evolve. I believe I am in good company. A few years ago, I worked on a project with the late C.K. Prahalad, who I think easily ranked in the global top-10 regarding business and economic thought leadership. Much of what I just said really came from him. Michael Porter published his Five-Forces article in 1979 . . . not one mention of ESG. . . . Fast forward to 2011 and his latest seminal work on Shared Value is 100% about ESG. Under the original Five-Forces, lengthening payables was a good thing; under Shared Value we have to assess the impact on supply chain innovation and workplace conditions, the former being an input to competitive advantage period, and the latter a component of effective capital costs.
I think some examples of you seeing it work would be instructive.
In my experience, true examples are usually very company specific. With a very broad brush, I have seen most ESG “edge issues” take roughly 8–12 months to meld into consensus. They sometimes involve simple information consensus overlooks. Sometimes it is a more involved analysis of information most investors are aware of but are not sure how to process. One brief example of the former: In 2012, a regulated utility named Portland General planned to build a 215-mile transmission line — a key value driver to the stock. We looked at the same project map everyone else did but valued the information differently. The company architected the line to run through a major Indian reservation. Environmental, social, and governance issues get amplified to different degrees in certain business climates. In this case, the risks to cost overruns, project delays, and even outright cancellation were heightened. These risks were not adequately in consensus. In the first half of 2012, management redesigned the transmission line to stop near the reservation’s border. In the second half, management canceled the project entirely, took a significant write-off, and lowered guidance.
So you think that ESG has “fully arrived” and is not just some oddball category, yes?
ESG is an information category just like any other; and it is a category that has risen in prominence to the value equation as the economic paradigm has recently evolved. Relative to more traditional financial information, ESG factors can be more easily overlooked and not adequately understood. If someone has an advantage understanding environmental risks at supply chain choke points, potential workplace disruptions at key, distant-market operations, the likelihood for delay and overruns of a value-driver project that involves multiple nontraditional stakeholders, then I believe, all else equal, that person has an advantage in valuation assessment and portfolio risk management.
What do you do to gain that advantage?
Gaining that advantage involves opening up to an expanded list of information sources; in some cases, reprioritizing them; learning to notice information that may have been safe to overlook 10 or even five years ago; and most importantly, accepting that the global economic paradigm has evolved so rapidly that it is semantics to debate whether the paradigm is new or not.
I think most would acknowledge that governance issues are priced into securities, but what evidence do you have that environmental and social factors are priced into the value of securities?
I think there is still headroom with regard to governance. It is also a central factor that can add measurable insight and conviction into environmental and social evaluations. For instance, when Coca-Cola experienced water-related problems in Kerala, India, we linked the valuation characteristics in part to an entrenched, interlocking board and central governance structure. Separately, having a supply chain choke point in a low-lying area of Thailand sharply impacted the computer and auto industries during the 2011 monsoon season. Or take a social example from Apple in 2011: Well before it became consensus, we looked deeply into supply chain workplace relations problems, identifying risks to the gross margin structure, new product launches, and potential brand value degradation, particularly in China. In the back half of 2012, I believe those issues negatively impacted Chinese sales, brand value — a key structural value driver — the gross margin and even the new product manufacturing curve.
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