Why ESG matters in downturns

This article is part of our Earth Week special report

COVID-19 and its effects have dominated headlines for more than two months now. For investors, seeing their portfolios tank each day is hard, especially for those close to retirement who might not have a lot of time to catch up.

In these tumultuous times, it may seem incongruous to focus on environmental, social and governance (ESG) considerations in investing. However, experts point out that it is precisely now that ESG considerations matter more than ever. Morningstar’s head of sustainability research Jon Hale found that in the U.S., ESG equity mutual funds and ETFs performed better than their closest conventional counterparts.

“Like all equity funds, sustainable equity funds suffered sudden and large losses during the first quarter of 2020 because of the coronavirus pandemic, but they held up better than conventional funds. Seven out of 10 sustainable equity funds finished in the top halves of their Morningstar Categories, and 24 of 26 ESG-tilted index funds outperformed their closest conventional counterparts,” Hale found.

“More stable, more secure, well-managed companies with solid environmental, social and governance (ESG) practices have generally responded well to the crisis,” agrees Calvert CEO John Streur.

“ESG priorities are actually central to building shareholder value and especially long value in companies. Many of the same priorities that we advocate for on behalf of investors in ‘normal’ times are also priorities today,” points out Anthony Schein, Director of Shareholder Advocacy at SHARE.

For investors who want to invest in sustainable businesses, it makes sense to keep an eye on the goings-on in various companies, to look at how they’re reacting to the pandemic and these unprecedented social measures. In their reactions and responses, you might find clues to long-term behaviour.

What to look for?
Companies that have sent a positive message and are creating a safe place are both acting responsibly and creating trust, will help protect their brands in the future, says Streur.

He says to keep a close eye on social themes that are financially material to a company’s success. For certain companies, this assessment should include examining a company’s supply chain and for others, worker safety may be critical.

“The most obvious piece of that is their treatment of workers in their own operations and in supply chains,” Schein says. He will be waiting to hear plans for how firms will manage through this crisis and how they will build resilience into their plans.

Job losses, layoffs, gig workers
One obvious fallout from the pandemic has been the impact on workers. Unemployment claims in Canada topped over a million, causing the Bank of Canada to take steps to help the economy recover.

“In many respects, the pandemic has really highlighted some of the existing challenges and inequalities in our economy and in our society. The employment effects of the pandemic and the economic crisis have tended to hit low wage workers the hardest,” Schein notes.

Companies that employ gig employees, including Uber (UBER), Lyft (LYFT) and AirBnB have been criticized for their lack of worker protections at this time.

“The response that we've often had in the past from these companies is that their workers are not really their responsibility, they're independent contractors, or being provided a level of flexibility really doesn't meet the expectations of consumers or of investors right now,” Schein said, adding that going ahead, from an ESG standpoint, the expectation is that companies will take responsibility for the health and safety of their people.

Streur agrees, adding that human capital management is a significant issue for these companies. “In our view, companies offering strong benefits and employee engagement will be better positioned moving forward,” he says.

Morningstar analyst Ali Moghrabi has further lowered his Uber and Lyft projections given the faster spread of COVID-19 in the U.S. and Europe. “We expect the current pandemic to impact Uber somewhat less than Lyft, because of Uber’s growing food delivery segment. We are reducing our fair value estimate for Uber to US$45 and for Lyft to US$50”, he says. AirBnB is not listed.

Executive compensation
An area that frequently comes up on activist shareholder radar is executive compensation. With rising unemployment and layoffs to protect business continuity, executive compensation is likely to be an even bigger focus for ESG investors for the next year.  

“We have seen a number of CEOs make public statements about forgoing their own salaries in order to support workers or contribute to certain relief funds. With the spotlight on this issue, we believe it will continue to be an area of shareholder activism. Executive compensation has long been a key component of our governance assessment and carries significant weight in our custom governance score,” Streur says.  

Schein points out that the question to ask is are the executives sharing the pain. “Certainly the slogan ’we're all in this together’ needs to mean something when it comes to compensation. We've seen a good number of companies taking positive steps in this regard, but certainly many others that have been silent or haven't announced an approach. We will be looking to see companies align their approaches to compensation, with broader principles around fair compensation,” he says.

Leaders emerging
Hale believes that the better relative performance of sustainable funds in the first quarter derives mainly from their focus on companies that have stronger ESG profiles/lower ESG risk and, secondarily, from their tendency to be underweight energy.

“But the bigger-picture rationale for sustainable investing is also important to keep in mind in a time like this. It's one that I expect will be strengthened in the aftermath of this global pandemic. Yes, sustainable investing is about delivering competitive financial performance on an ongoing basis, aided by the insights of ESG analysis, but it's also about helping companies move toward a more long-term stakeholder-centric model of corporate behaviour. That longer-term impact, not short-term performance, is the motivating factor behind sustainable investing. When all is said and done, I think we'll find that companies already moving in that direction will be the ones remembered for helping us get through this crisis, and demand will grow for others to follow suit in the future,” Hale says.

In this pandemic, companies that are able to quickly adapt to the changes in circumstances and demand trends will likely come out on top, Streur says. “For example, we saw Walmart's (WMT) announcement that the company will be hiring 150,000 new associates through the end of May to work in stores, clubs, distribution centers and fulfillment centers. Utilizing resources to focus on sanitization and restocking, along with treating employees well, may help the company sustain its long-term advantages,” he says.

“With unrivalled scale, prodigious procurement strength, a strong brand, and a growing e-commerce platform, we believe Wide-moat Walmart is the only American retailer that can compete comprehensively with Amazon’s retail offering. Although it should lift fiscal 2021 sales (albeit at a slight margin cost), we do not expect the COVID-19 pandemic to materially alter Walmart’s long-term standing,” says Morningstar analyst Zain Akbari.

In financials, Streur believes firms that balance the needs of stakeholders throughout the pandemic and beyond will be best able to capture the inevitable flight to quality, gain market share and position shareholders to capture value over the long term.

“Additionally, the ability for employees to work from home, data security, and business continuity planning is critical. Bank of America (BAC) has come out as a leader on a number of these fronts and has increased the minimum wage for employees and promised no layoffs,” he notes.