Don't Forget the "S" in ESG

On the surface, it’s easy to see why the environmental and governance factors get so much of investors’ attention – they are easy to measure and understand. And in that, we can more easily define/model how they can benefit (i.e., profit) from these factors.

In the case of a utility, we can measure and see how their investments in solar and wind power directly enhance their bottom lines. Subsidies for new generation, cap & trade policies and such can quickly be boiled down to balance sheet items. For a manufacturer, we can see how water savings lowers costs and enhances margins.

The same can be said for governance issues. We have years of evidence that firms with good management and corporate mentalities produce better returns. Focusing on low debt, reputable dealings, no bribes, and other similar governance issues do indeed produce stronger returns. Again, this is easily quantifiable.

However, when looking at the social benefits of a firm or its products? That’s a harder nut to crack.

Investment ratings agency and research firm, S&P Global defines social factors as “How a company manages its relationships with its workforce, the societies in which it operates, and the political environment.”

Essentially, the “S” looks to quantify ideals like health and safety, human rights, labor rights, and equality in the workforce. Many of these issues have been moved to the forefront, especially with the political environment over the last few years as well as during the COVID-19 crisis. Responses to employee and consumer health during the pandemic – along with the Black Lives Matter movement, the #MeToo movement and Fight For $15 – have put the target squarely on social factors.

On the surface, this may seem a little harder to grasp than simply adding solar panels to a firm’s generation mix or reducing the amount of paper it consumes. The reality is that navigating these social factors can and does increase returns and reduce risks for companies.

The proof is in the pudding. And this comes from numerous studies looking into these social factors and stock/company outperformance. A 2006 study between Oxford and New York University showed a direct link between a firm’s financial performance and its social performance. Similarly, a 2015 study by the Investor Responsibility Research Center Institute and Harvard found plenty of positive correlation between how firms manage their workplaces and financial performance. “Happy” employees were able to boost financial performance more than specific policies designed to cut costs/benefit the corporation at the detriment of its workers.

Elsewhere, there have been numerous studies on gender and diversity in the workplace. According to Morgan Stanley research, organizations with more female employees across all levels of the organization outperformed their less gender-diverse peers by 3.1%. Return-on-equity was higher as well, while return-on-equity volatility was lower.

The flipside of not focusing on these metrics can be considered a risk for a stock these days. Consumers, other businesses, and political leaders are quickly turned off when news breaks of a major scandal or social breakdown at a company.

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The great part is that as ESG has grown in popularity, so has the ability to measure the impacts, research, and score of such metrics. This has demystified the social aspect, making it as easy to understand as the environmental and governance metrics. And that makes it a worthy and easy-to-access investment theme.

For example, both the Pax Ellevate Global Women’s Leadership (PXWEX) and the SPDR SSGA Gender Diversity Index ETF (SHE) focus on gender-specific issues and firms with diverse workforces. While the iShares MSCI Global Sustainable Development Goals ETF (SDG) focuses on a variety of social impact goals like expanding education and workers’ rights.

Overall, the “S” used to be a difficult nut to crack. But these days, with advanced screening methods and continued research, we now know the positive impacts of focusing on the social aspects of a firm. And the message is loud and clear: Investors need to take the “S” just as seriously as the other two ESG metrics when crafting their portfolios. The beauty is that they now have plenty of tools to add the social metric in spades.

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