Acolytes of Benjamin Graham, Peter Lynch, John Moody and Henry Varnum Poors have long ignored or struggled with the thought of incorporating moral values and social costs into the valuation of a company's cash flows. In recent years, the investment industry has developed a consensus that incorporating environmental, sustainability and governance risks into investment valuation is generally consistent with fiduciary responsibilities. This approach has come to be called by the general term, ESG integration.
ESG integration, as commonly practiced, does not include the practice of excluding companies based on attributes that are not considered to be material investment risks. One of the primary factors in the success of a company is having a comprehensive and accurate view of the risks facing that company. Companies that devote a great deal of resources to enterprise risk management should be better positioned to face challenges than more poorly prepared competitors. In the same sense, investors who comprehensively understand the risks facing an issuer are better positioned to make proper relative valuation comparisons. The old phrase, "what gets measured, gets managed," gives a window into why this is true. Companies and investors who are poorly prepared for unanticipated challenges that arise can be expected to react poorly.
Investors who ignore important information about issuers run the same risk as chemistry students who only read the even-numbered chapters of a textbook. Developing a complete picture of the risks and opportunities facing an issuer must include an examination of ESG factors. Investment analysts who rely on the news feeds that appear on Bloomberg terminals might very well miss a series of small adverse events that make it obvious that a company is poorly managed. As an obvious example, comparing the labor safety records of two mining peers can give important insights into how well the companies are managed.
In fixed income, it is important to remember that credit ratings attempt to measure an issuer's creditworthiness. Part of creditworthiness is an ability to withstand adverse circumstances. Generally speaking, higher rated companies should be able to better withstand adverse ESG events than lower rated companies. At one point, BP PLC estimated the cost of the Macondo oil spill was $62 billion. These costs could easily have driven a smaller, lower rated peer into bankruptcy, leaving bondholders unpaid and in court hoping to get their money back. Because of BP's financial strength and size, shareholders bore the full cost of this disaster.