On this week's episode of Industry Focus: Energy, host Nick Sciple chats with Motley Fool analyst Maria Gallagher about ESG investing -- that's environmental, social, and governance. Maria walks listeners through what ESG practically means for a company, why this investing style has taken off recently, why ESG doesn't mean sacrificing growth, how investors can find companies on either end of the ESG spectrum, some risks to watch out for with rankings and tracking over time, and more. Plus, she illustrates her typical ESG investing process with one of her favorite ESG companies -- Trex (NYSE:TREX), an alternative deck builder. Tune in to learn more!

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on Aug. 1, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, Aug. 1, and we're discussing ESG investing. I'm your host, Nick Sciple. Today I'm joined by Motley Fool analyst Maria Gallagher. What's up, Maria?

Maria Gallagher: Hi! Thanks for having me!

Sciple: It's great to have you on the show! It's the first time on Industry Focus! You've been at the company, what, not even a year yet. How are you settling in? What are you working on?

Gallagher: It's pretty good! I've now been here actually over a year. I've been on the investing team for seven months. We just finished doing our IDP, which is our investor development program. Me and three other guys finished, and we're all rotating through different services. Right now, I'm working on the ESG service.

Sciple: Which brings us to what we're discussing today. ESG, for folks who don't know, it's an acronym that stands for environment, social and governance issues. It's been evolving as an investment strategy in recent years. Before we dive into, what ESG is, can you expound on what we're looking at when we talk about those environment, social and governance factors, and what that means behind the whole ESG investing trend?

Gallagher: Yeah, definitely. ESG is a lens to look at companies. The first is environment, how the company impacts the environment, things like their carbon emissions, the amount of water they use, their supply chain, how transparent they are with that. Then you go to the social aspect, which is how they treat their employees, how the employees are paid, the diversity, how they treat their suppliers. Then the governance is that last lens to look at the company with, and that indicates things like the CEO pay, the C suite execs and the board of directors, their diversity, their pay, their compensation, their bonuses, things like that. If you combine all three, it's a pretty holistic view of a company and how it rates on those three scales determines if you think it's a prime ESG company to invest in.

Sciple: Right. When we talk about ESG, and we're looking at these factors, there are some other investing strategies folks may be familiar with -- talking about like conscious capitalism, socially responsible investing. How does ESG maybe compare and contrast what those styles of investing, and what makes it different?

Gallagher: It's confusing, because there are a lot of acronyms, and there's no one standard. I think one of the best ways to understand it is, ESG is an inclusionary screening. It includes all these different companies, whereas things like socially responsible investing is more exclusionary. It'll exclude companies and industries that people don't want to invest in, things like the sin stocks -- tobacco, alcohol, gambling -- whereas ESG includes everything and ranks it on this different scale. That's, I think, the biggest difference, but they're all same sides of different coins. Is that the expression?

Sciple: Yeah. I guess you could say that ESG might result in some of the same outcomes that you would see from SRI. An ESG framework might lead you not to want to invest in tobacco stocks for a number of reasons. However, it's a different framework to approach actively selecting stocks vs. excluding them from your universe. Is that fair?

Gallagher: Exactly.

Sciple: We've seen over recent years, ESG has grown as a strategy, more and more funds have been devoted to this area of the market. Can you throw us some data on how ESG has grown over time, and maybe some theories on what's been driving this increased interest in ESG investing?

Gallagher: Yeah. This past year, the total ESG assets jumped to $12 trillion. It jumped 38%, it's now 26% of the total investable assets. A way to think about that is, $1 of every $4 invested is invested in an ESG fund, which is a really cool thing. It's grown in popularity, I think, in terms of, more millennials are now investing, and more millennials are interested in socially responsible things. There was a study that said that millennials are twice as likely to invest in a socially responsible fund. So, when you have that customer drive, then the asset managers are now interested in doing more ESG funds or ESG ETFs, and companies realize that this is the way investors want, this is what their shareholders want, so they start considering more sustainability and more environmental things in their decision-making. 

One of the cool things I found when I was doing some research is, now 72% of companies in the S&P 500 actually release a sustainability report, which is one of the ways that shows how these companies are taking ESG things more seriously as it grows in popularity.

Sciple: Yeah, you have to give the people what they want. It's increasingly top of mind with climate change and things that millennials care about. These issues are important to folks. But it's not just tailored to these social issues. You can actually see some increased returns from using an ESG framework to invest. Can you share some data that we found on that?

Gallagher: Yeah. There is actually a common misconception that you have to sacrifice returns if you want to invest for the greater good, which is not true. JUST Capital has a list of their JUST companies, which is how they rank ESG companies. They found that companies in the top quintile have 18% to 22% lower volatility, 6% lower beta, 5% shallower drawdowns, and 4.5% higher ROIC than companies that are in the bottom quintile. Also, not just company-specific, if you're looking at those ETFs, more passive, or mutual funds, you can compare some of those ESG ETFs to the S&P 500, or the S&P index, and a lot of them outperform. You don't have to sacrifice returns if you're interested in ESG investing.

Sciple: It stands to reason, if you have good relationships with your employees, you're taking care of your environment, you're not going to get hit with a big scandal like maybe VW got for an emission scandal. It positions you as a company going forward to be stable. We've seen that in the returns. 

Now, if you want to invest for an ESG strategy, what should folks be paying attention to? I know you and some other folks at The Motley Fool have done some work trying to figure out what we should focus on and a framework to use to invest for ESG. Can you share that with us, and how we've been thinking about that here at The Motley Fool?

Gallagher: Yeah. Two of our colleagues, John Rotonti and Alyce Lomax, created this really great 10-point checklist for ESG. You can find it if you go to the fool.com ESG hub. [laughs] I think it's just fool.com/esg.

Sciple: We'll drop a link in the description for you, folks.

Gallagher: So, the 10 points, I think it's great because it combines both of those ESG principles with the more financial principles. The first five of the framework are ESG, so it's things like, does the company treat its employees well? Is it a good steward for the environment? And then those final five questions go more toward the financials, if they can generate organic revenue growth, some things with free cash flow and ROIC. You can get a check or an X. If a company gets more than seven checks, we score it as a passable ESG company. We've scored a couple of companies, and we continue to score companies and throw those into the ESG hub so you can look at how we think of all of these companies.

Sciple: You can use that ESG framework to identify the companies that are attractive to you both on those ESG factors as well as the things we normally look at as investment analysts -- free cash flow, things like that. For the ESG factors that folks want to pay attention to, you've mentioned, more and more companies are coming out with sustainability reports and those sorts of things. Where should investors go to look to confirm those ESG checks? Where should they go to find the information they need to confirm that this company is taking care of its employees, and checking each of those boxes on the ESG framework?

Gallagher: The sustainability report's a great place to start, see where the company is focused on, what their goals are. Another great thing to look at is, I love looking at the proxy statement. That does a lot with compensation. I believe this year is the first year that companies were required to disclose their CEO to median pay employee ratio, so, how much more the CEO is making than that median employee, which I think is a really important thing to look out for both employee treatment and also the CEO pay. You can look at things like Glassdoor. There are all of those Fortune, Forbes lists of best and worst companies to work for, for more of that qualitative stuff. Or, any CEO interviews. And then, all of the other things you generally look at with companies, like 10-Ks, conference calls. ESGs specifically have some really cool resources. There's a company called As You Sow, which has a screen where you can plug in an ETF for a mutual fund and see if it invested in companies that hurt deforestation, or don't have a lot of gender equity. There's the JUST 100 list that I mentioned. There's a company that's called Arabesque, where you can put a specific company in, and it gives you their ESG ranking. There are a lot of cool ways where, if you're not sure, you can see what other leading thought leaders or industry experts, their opinions on those companies?

Sciple: As you list these third-party companies that provide ESG research, are you seeing, as interest in ESG is ramping up, the resources available to find the information you need to invest in ESG is starting to increase more and more over time as well, it's becoming easier and easier to invest this way? Would that be fair to say?

Gallagher: Yeah, definitely. I think it's interesting because there's a lot of resources, but it also means you have to do your due diligence more. There are definitely some ETFs or things that you can look at that seem like they might be great for the environment, but if you do a little more digging, they might not be as great. With all the more resources comes a little bit more of a necessity to do your research.

Sciple: Yeah. To that point, doing your research, how you might use this framework to look at a company, I want to ask you to share with us your favorite ESG company right now that you're paying attention to, and how you would go through that framework. Can you do that with us now? What's your favorite ESG company right now?

Gallagher: My favorite company is a company called Trex. Have you heard of it?

Sciple: I have heard of Trex. 

Gallagher: From me! [laughs] 

Sciple: For our listeners who haven't, why don't you tell them about it?

Gallagher: OK. I love Trex! It is a decking company. They make composite decks. They're made out of recycled plastic bags and reclaimed wood fiber. I'll go through a couple of the checklist items. We do have on the ESG hub -- going to plug it again [laughs] -- we did a full breakdown of Trex. I'll do a highlight reel of those things. 

The first thing we looked at is employee treatment. The pay ratio for Trex is really low. It's 39.4X. The median employee makes over $66,000, which is over the national average. For context, most CEO to median pay ratio is more in the 200X, 300X [range]. So, 39X is really reasonable. 

Are they good steward of the environment? Yeah. Sustainability is their business model. Some great facts about Trex -- a 500 square foot deck has 140,000 plastic bags in it. 500 million pounds of recycled plastic is diverted from landfills by them each year, which is a lot. 

One of the areas they need to work on is, if you look at diversity and inclusion, there's only one woman on their board. All of their executive officers are men. That's something the company needs to prioritize, I think, and work on. 

If you look at their ethical corporate governance, they have things like their low CEO to worker pay ratio. They have really strong stock ownership guidelines. There's a separate chairman and the CEO, which are all things we like. 

And then, the last ESG question we think about is if they promote it in their business model. They literally turn trash to treasure. I think it'll be hard to find a company that has ESG more ingrained in them then Trex.

Sciple: When you look at Trex as a business, they're in this market for alternative wood products. When you start looking at their financials, and that side of analyzing the company, what really stands out to you there, opportunities for them to grow and continue to be profitable into the future?

Gallagher: I think they're a great company. When you look at their financials, one of the things that jumps out is their gross margins. They're up to 43%. Between 2013 and 2018, they jumped from 29% to 43%. They have a healthy really balance sheet. They have strong organic revenue growth. That's helped by the tailwinds of more people being interested in sustainable decking. They're a little bit more expensive upfront, but over the top life of the deck, they don't have things like staining or termites or anything that could ruin a deck. Trex doesn't have that problem, which is awesome. They have a high ROIC. It's 38%. Their management team, their incentive compensation is partially based on free cash flow. We really like the management team of this company. If you look at their risk profile, it falls right in the medium category, because it is discretionary spending, and it is a little more expensive. That always comes with some risk. There's a good amount of customer concentration, which comes with some risk. But it's not too high. We feel that it's a good company and it does well for the environment.

Sciple: Right. As you see more and more millennials become homeowners, folks that we've said are interested in this ESG type investing, they're probably going to be ESG focused consumers. You would see there's some natural demand there. 

Going away, once you've identified an attractive ESG company and you've invested in it, how do you as an investor track this company over time and make sure that it's following through on the ESG initiatives they've set out to do? How do you track that and confirm what management has been saying?

Gallagher: It's a layer you add onto your investing thesis. The same ways we all monitor all companies, you make your investing thesis a couple of points, so, if the stock takes a hit, you see, is that reasonable, is it not reasonable, based on what my investing thesis is? One of my parts of the investing thesis is their sustainability and those metrics that the company is monitoring. You look at the changes in their sustainability report, if they're changing the metrics that they're using to show their success in those things, if there's big turnover in CEO or high-level executives that make sustainability a priority, any sort of thing like that, that would draw some red flags. But, write down why you like the company and their sustainability, and then just continue to monitor why you like that and why that might change.

Sciple: Awesome! Maria, going away, thank you so much for coming on and sharing stuff all that ESG stuff!

Gallagher: Thanks you for having me!

Sciple: For our listeners that want to stay up to date with this stuff, we'll drop in some links to our ESG articles, and we'll have a link to our ESG hub if you want to stay paying attention to this stuff. Hope to have you on again soon, Maria! Always great to chat with you!

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for his work behind the glass! For Maria Gallagher, I'm Nick Sciple. Thanks for listening and Fool on!