From the November 2012 issue of Research Magazine • Subscribe!

A Win-Win Approach

There’s a long list of challenges facing the world and the companies that do business in it: climate change, access to energy resources, adequate food supplies, clean air and water, health care—and the list goes on. These issues, though certainly complex, do create many investment opportunities for companies that can address them with sustainable solutions. Here’s how.

Sustainability practices address these challenges, according to the U.S. Environmental Protection Agency and other sources. “Sustainability is based on a simple principle: Everything that we need for our survival and well-being depends, either directly or indirectly, on our natural environment,” the organization says. “Sustainability creates and maintains the conditions under which humans and nature can exist in productive harmony [and] that permit fulfilling the social, economic and other requirements of present and future generations.”

SAM Group Holding AG, an investment firm in Zurich, Switzerland, focusing exclusively on sustainability investing, identifies several global megatrends: long-term water, energy, climate, materials, agribusiness, and healthy living. Investors can potentially profit from focusing on companies that are meaningfully and financially associated with these themes.

Investors “continue to underestimate the impact of sustainability trends on companies’ competitive landscape,” the SAM Group notes on its website. “This leads to market inefficiencies that sustainability investors can exploit. SAM believes that sustainability is a company’s capacity to prosper in a competitive and changing global business environment by anticipating and managing current and future economic, environmental and social opportunities and risks. Companies that address these factors through innovation, quality and productivity enhance their ability to generate long-term shareholder value.”

Sustainable investing is sometimes confused with socially responsible investing, but they differ, says Joseph Keefe, president and chief executive officer of Pax World Management LLC, a sustainable investing management firm in Portsmouth, N.H. In 1971, Pax World launched the first U.S.-based socially responsible mutual fund, an approach that was generally defined as investing with your values, says Keefe. This approach required investors to screen out corporate activities or products to which they objected, such as weapons, tobacco, alcohol or gambling.

In contrast, sustainable investing defines itself more closely with what it invests in, says Keefe. Its aim is to focus on investments in companies that have stronger sustainability profiles, because those profiles are considered to be strong indicators of good management and more forward-looking corporate entities. In time, those companies should produce better financial returns, according to this approach.

Identifying Leaders

Identifying sustainability leaders follows a general and rigorous process, experts say: (1) Find companies with strong sustainability practices that are pursuing viable solutions, (2) analyze those companies for their growth potential and relative valuations, and (3) identify the best-of-class in their respective sectors. 

To compile its Dow Jones Sustainability Index (DJSI) World index, SAM invites the world’s 2,500 largest companies (in terms of free-float market capitalization) in all industry sectors to participate in its annual Corporate Sustainability Assessment (CSA). An additional 800 companies from emerging markets are also invited to participate. 

“The CSA focuses on a company’s long-term value creation with over 100 questions on financially material economic, environmental and social practices,” SAM explains online. “Over half of the questions are industry-specific, as SAM is convinced that sector-specific sustainability risks and opportunities play a key role in a firm’s long-term success. The other half includes questions on general sustainability issues, such as corporate governance, product stewardship, and talent attraction and retention.” 

After the assessment, companies are included in the DJSI World if their sustainability performance ranks among the top 10% of their industry peers. The list of companies in the index can change each year, depending on assessment’s results. 

In 2012, the largest additions to the DJSI World included Microsoft Corp., Canadian National Railway Co., and Target Corp. The largest deletions were International Business Machines Corp., GlaxoSmithKline PLC, and United Technologies Corp. The DJSI World 2012/2013 index—effective as of Sept. 24—has 340 components; 41 companies were added, and 41 firms were deleted. 

Each year’s index roster, including the current version, reads like a “who’s who” of global companies. According to DJSI World Index Fact Sheet, the largest components in the index are General Electric (weight: 2.72%), IBM (2.67%), Nestle S.A. (2.56%) and Johnson and Johnson (2.29%). Financials, health care, consumer goods, industrials and technology are the largest sectors. Country allocations favor the large, developed markets: the United States, United Kingdom, Switzerland, Germany and France account for 70% of the roster’s market capitalization.

Pax World Investments focuses on companies’ environmental, social and corporate governance (ESG) policies as part of its investment management process. “You look at all the traditional financial factors that other money managers look at,” says Keefe. “But in addition to that, you look at the company’s environmental, social, and governance record. You also look at a whole host of environmental, social and governance indicators.”

Performance

The ESG factors are material, Keefe argues. He points to extensive research supporting the contention that companies’ ESG policies influence their profitability and long-term returns. “It is certainly our strong belief that integrating ESG factors into portfolio construction can both mitigate risk and therefore address beta, and actually promote better performance [and] be a source of alpha. And there is research,” he says. 

“All kinds of studies suggest that this is the case,” explains Keefe. “A recent Deutsche Bank study evaluated 56 academic studies of sustainable investing and concluded that ESG analysis should be built into any portfolio or any investment process for any serious investor. [The study found] that over time funds that focus on ESG should have an advantage and should be positioned to capture superior risk-adjusted returns if they are managed well.” 

The June 2012 Deutsche Bank study had several key findings: 100% of the academic studies agree that companies with high ratings for CSR (corporate social responsibility) and ESG factors have a lower cost of capital in terms of debt and equity; 89% of the studies examined show that companies with high ratings for ESG factors exhibit market-based outperformance.

Based on such conclusions, Keefe says, “Just as it wouldn’t make sense to ignore a company’s P/E ratio, if that’s considered material, or it wouldn’t make sense to ignore a company’s cash flow, if that’s considered material, we don’t think it makes sense to ignore a company’s environmental, social and governance record, because those things quite often are material as well.”

Similar conclusions were reached in a white paper released by SAM about a year ago: “The results reveal a positive relationship between sustainability and financial performance, as measured by stock returns, demonstrating the superior alpha potential of the sustainability leaders identified by SAM’s sustainability data. This is reflected in the positive information ratio (0.53) of the portfolio of sustainability leaders. Moreover, the performance of the long/short strategy was exceptional during crisis and post-crisis periods, suggesting that sustainability optimal portfolios inherently have better risk characteristics ... Investing in sustainability leaders ultimately contributes to superior long-term investment results with improved risk-return profiles.”

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