Why ESG Investing Is a Win for All

In this episode of Motley Fool Answers, Alison Southwick is joined by Motley Fool personal finance expert Robert Brokamp and senior writer and analyst Alyce Lomax to discuss ESG investing. First, Robert talks about the recent drop in stocks, the changes in homebuying trends, and the rise in personal savings. Later on, Alyce dispels some myths and tells you all you need to know about ESG investing, how to find and invest in such companies and why, and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on June 15, 2020.

Alison Southwick: Hey, this is Alison. Before we get started with the show, I have a favor to ask. Yeah, I know, but here's the thing, The Motley Fool's birthday is coming up, and I was hoping that listeners and members like you might be up for sharing a birthday message with Tom and David and all the rest of us at The Motley Fool who work hard to help you become smarter, happier, and richer every day. So, if you can do me a favor, drop me a line at [email protected] and just say, "Alison, I'm here to help," and we'll take it from there. Thanks!

This is Motley Fool Answers. I'm Alison Southwick, and I'm joined, as always, by Robert, the Bro, Brokamp. Hi, Bro. How are you doing?

Robert Brokamp: Just fine. And how are you, Alison?

Southwick: Doing OK. In this week's episode, we're joined by Alyce Lomax. She's an analyst here at The Motley Fool, and she's going to help explain ESG investing. That stands for environmental, social, and governance. We're going to find out how do you analyze a company through this framework and make sure if they're really walking the talk, and do these companies outperform? Let's find out. All that and more on this week's episode of Motley Fool Answers.

So, Bro, what's up?

Brokamp: Well, guess what, Alison. I got three things for you.

Southwick: [laughs] Oh, we're back to the three things. It's been a while.

Brokamp: [laughs] The economy must be opening up. Nature is returning to normal.

Southwick: Yeah, the natural order of things. Here we go.

Brokamp: Yes. OK. But, of course, No. 1, I have to start with that crazy old market. So, last week, we mentioned how the S&P 500 experienced its best 50-day rally in its history. Good times continue to roll through the first part of last week, culminating on Wednesday with the Nasdaq closing above 10,000 for the first time ever.

Then came Thursday. On Thursday, stocks suffered their worst one-day sell-off since March 16, with the Dow dropping more than 1,800 points, bringing it down 6.9%; S&P 500 dropped 5.9%; Nasdaq down 5.2%. And the Russell 2000 Index of small caps down 7.6% all in one day.

Why did stocks drop? Well, if you read the financial media, they said one reason was the increasing number of coronavirus cases, but I have to say, honestly, I don't know why that's a surprise, right? Economies are opening up, testing rates are going up, the virus didn't go away, so were people expecting cases just to disappear, especially when you have half the country going out without masks? So I don't quite get it.

So who knows if that's really why stocks dropped. Another reason could be that the Federal Reserve closed its meeting last Wednesday, concluded at the end of the day with a news conference from Jerome Powell. He warned that the economy could shrink 6.5% this year, though, hopefully we'll rebound about 5% next year. That said, he made it clear that these were not official forecasts, given the difficulty with forecasting these days. Basically, he said, it all comes down to the virus. Will we be able to control it or not? And since nobody knows, it's very difficult to make any economic projection.

But he did make clear that interest rates will be kept very low through this year, through next year and probably through most of 2022. He said, "We're not thinking about raising rates, we're not even thinking about thinking about raising rates. What we're thinking about is providing support for the economy. We think this is going to take some time."

Anyways, stocks rebounded a little bit on Friday, but opened up down significantly this morning. This morning being Monday, June 15, which is when we're taping this episode, but, and I'm going to check right now, because things move so quickly, yep, here we are, right, so [laughs] the Dow opens down 400 points, and now it is up 250 points. You just can't keep a good market down.

So, the bottom line is, I think, given how much the stock market has rebounded since March, I think we're going to see days where the market also drops significantly. It's perfectly reasonable for the market [laughs] to take a breather every once in a while. What I'm really curious about is to see what happens at the end of July, when many unemployment benefits expire and the moratoriums on evictions and some foreclosures will expire. Things could become very difficult for many, many Americans. So, I'm going to be very curious to see what happens then.

No. 2, the mother of all bidding seasons, that comes from a headline in an article in Barron's by Jack Hough, on the pandemic's impact on the real estate market, which I find rather fascinating, because we are in the middle of a recession, yet home prices are holding up pretty well. In a previous article he had spoken with the Yale economist, Robert Shiller, who predicted the house prices in the suburbs are going to rise faster than in the cities as folks seek more social distancing living arrangements. Well, it turns out that Dr. Shiller is on to something. Preliminary information indicates that this is, in fact, is what folks are doing. The article included comments from Glenn Kelman, the CEO of Redfin; by the way, that stock is up 50% this year. And Kelman says traffic for online listings for houses in the suburbs and small towns has outpaced that for big city traffic by 164% over the last two months. Meanwhile --

Southwick: I just found out yesterday, our neighbors are moving to Vermont.

Brokamp: Oh, really?

Southwick: Yeah. They're like, "Yeah, we're leaving. We're going to Vermont." And I'm like, "Why?" Well, they can live from anywhere, and they're saying, coronavirus. They're like, we want to live out in the country and get a little distance between us and people. They were debating about moving to New York City before the coronavirus hit, so they're going like a complete 180.

Brokamp: Yes. Well, I'd say, it'll be interesting to see how quickly they sell their house because -- and I don't know if people consider this area to be, you know, high-density or not, but inventory is extremely low. So, according to the National Association of Realtors, the inventory for homes for sale in April was the lowest on record ever for that month, because people just didn't want to sell their homes. So, you have increased interest, people wanting to buy a home, but low inventory. This is why Kelman says, this Summer is going to be the mother of all bidding war seasons, especially in these outlying areas. He said "There's nothing to sell and there are so many people who want to buy, they are emboldened by the stock market and low interest rates." By the way --

Southwick: We'll have three houses on our block for sale. So, come move into our neighborhood, anybody.

Brokamp: It's a great neighborhood. Actually, my wife and I were --

Southwick: Thank you.

Brokamp: It's great. Old Town, Alexandria, wonderful.

Southwick: Yes, it's great. Three houses. I can see the signs right from here, so.

Brokamp: Yeah. One final thing from Kelman, he said that the pandemic is changing preferences. So now, when people are looking for homes, they're no longer looking for the open settings. They're looking for his and hers Zoom rooms for conferencing. So, they're looking for these small rooms where you can work. It's pretty fascinating.

Anyway, we're starting to see the signs of the market picking up. The number of mortgage applications for new home purchases jumped 17.5% in the week ending May 29, according to the Mortgage Bankers Association. And home prices rose 3.1% year over year in the last two weeks of May according to Realtor.com.

So, the bottom line is, that despite [laughs] the fact that we're in a recession and that the stock market is exceptionally volatile, owning a home is turning out to be a pretty nice diversifying asset this year.

And finally, No. 3, a bull market in your bank account? So, the United States, not known to be a country of savers, the personal savings rate at the end of 2019 was 7.7%, which is better than the 5.4% we saw at the beginning of this century, but far below the 17.3% in 1975, which was the all-time high. That is, until this year, on May 29, the Department of Labor announced the savings rate for April, which was -- do you know the answer to this?

Southwick: No.

Brokamp: Thirty-three percent. Americans on average saved 33%. Holy shaving cream! America, good job. Obviously, the surge in saving was due to the fact that the economy was shut down and people were staying home, which can be a rather low-cost lifestyle. But also, many bank accounts have been augmented by stimulus payments and unemployment benefits that result in people making more money than when they were working. Bank of America CEO Brian Moynihan told CNBC that checking accounts have 30% to 40% more money in them compared to three months ago, but there are signs that folks are beginning to spend again. He said, "That means that the stimulus is still in the accounts and it's going to be spent." Since more than two-thirds of the economy is driven by consumer spending that could be good news for the overall economy. That said, if you are personally behind in your retirement savings or you need to replenish your emergency fund, I hope you keep socially distancing your wallet until you're back on track with your savings goals.

And that, Alison, is what's up.

Southwick: ESG investing, the letters stand for environmental, social, and governance, I think. More and more companies are recognizing the importance of communicating a commitment to a stakeholder model and not just maximizing shareholder value. Alyce Lomax, an analyst here at The Motley Fool, joins us to discuss all things ESG, what does that encompass, should you invest through this lens, how can you tell if a company really is walking the talk. Alyce, thank you for joining us.

Alyce Lomax: Thank you for having me.

Southwick: Before we get into it, why don't you share with us a little bit about your journey that led you to The Motley Fool. I know you've been on the show before, but it's been a while. So, let's have you reintroduce yourself to our listeners.

Lomax: Sure. I have been with The Motley Fool for about 16 years now. So, it's been a good bit. I did a variety of different writing jobs in the financial profession over many years. And The Motley Fool's culture and vision really attracted me, so that's why I've been here for such a long time.

Southwick: Yeah. Well, you're in here with some veterans too. I mean, Bro and Rick, I think have a few years on you, right?

Lomax: Yes, they do.

Southwick: Four or five maybe. I'm the newbie here with only nine years under my belt, so. All right. Well, before we get into ESG investing, I think it's helpful context to sort of understand the history a bit, particularly the mindset of maximizing shareholder value. Can you talk a little bit about what that idea is, when was it prevalent, and what's happening now and the shift in thinking?

Lomax: Absolutely. In 1970, the economist Milton Friedman came up with what is now known as the Friedman Doctrine that said that, basically, shareholders are the most important stakeholder, and that companies should always maximize shareholder value. Over about the last 10 years or so, a lot of people are beginning to recognize that stakeholder-centric business is actually a stronger way to build a business for the long term. Under the stakeholder model, shareholders are still a stakeholder, but you're also thinking about other stakeholders, like, employees, the environment, communities. It's a much more holistic approach. And these days you even have many business heads signing on to the idea that business has to look out for all stakeholders.

Southwick: And when you think of movies, like, Wall Street or something like that, which take place in the '80s, and it's men in French cuffs with cufflinks and you just imagine them talking about maximizing shareholder value, and we got to lay off some employees so we can become more efficient and we got to pollute the environment, but you're right, you just think about, like, corporate profit, the '80s, but I guess it had been going around for a while. And so, when did we start to see, kind of, the shift to thinking more about more, [laughs] more than just your bottom line?

Lomax: I would definitely say it's been within the last 10 years or so that there has been a shift. ESG investing is very similar to socially responsible investing, which actually cropped up in the '70s. And socially responsible investing was generally blocking out certain companies that go against certain moral or ethical components.

Southwick: So, I'm not going to invest in tobacco companies or companies that make guns, right?

Lomax: Exactly. And I believe that the prevalence of socially responsible investing over the years definitely was a reaction to that shareholder primacy type of idea. And the idea that not all investors are going to want to own shares in companies that treat other stakeholders in the world in a poor manner. However, ESG investing has come around within about the last 10 or 15 years and that is actually a data-driven approach to looking at environmental, social and governance aspects and really targeting high-ESG companies as companies that are going to perform better over the long term.

Southwick: OK. Well, let's break down the letters. So, let's start with the "E." And what are we talking about when we look at environmental, and how do you measure it and maybe what are some companies that are an example of really living in that "E"?

Lomax: All right. When looking at the "E" part of ESG investing, investors look at things like climate change policies that companies have put into their sustainability reports, which is the first place you're going to look. And that's going to be carbon footprint data; energy usage data; resource data, how they use water, that sort of thing; recycling; just everything having to do with environments and reducing climate change.

And one really good example of a company that is doing a good job in this area is Microsoft. I think they're good in a lot of the ESG areas. But for example, Microsoft has been carbon neutral since 2012, but earlier this year they actually put out a pretty audacious goal. They said that they are going to be carbon negative by 2030, and they're going to be removing historical carbon emissions by 2050. And they've also put together a $1 billion climate innovation fund. So, these are the kinds of things you're going to be looking for, are companies that are not only disclosing environmental information, but also putting out strong goals and then letting investors know how they're doing against those goals.

Southwick: So, when you said Microsoft, both Bro and my eyebrows went up, because that was not what I was expecting you to say. How does a tech company do this? How are they going to do that?

Lomax: You know what, I am not actually sure how they're going to go carbon negative. So, that is something that I think remains to be seen, but Microsoft is a very innovative company. Clearly, they're in the tech field. And they've done a lot of very interesting things, like, green data centers. trying to make their data centers more environmentally friendly, basically. So, a company like Microsoft, I think, you have to give them a lot of credit for actually having that innovative view on things.

Southwick: Yeah. All right, let's move on and talk about the "S," or social.

Lomax: The social component of ESG investing has to do with looking at things like how employees are treated at companies, looking at diversity statistics, whether the companies are disclosing gender and racial diversity in their workforce, how they treat people of different genders and races. It has to do with community, whether they are giving back to communities. It has to do with product safety types of issues, consumer safety.

A lot of people are going to understand the social part, because we all understand what it's like to be an employee or a consumer and how we are treated as that kind of as a stakeholder.

Southwick: And what's a company that you'd want to lift up as an example of doing something innovative with the "S," the social?

Lomax: Well, I think Etsy is a good example of a good S-type of company right now. Most of its store operators are actually women, so it is helping a lot of female entrepreneurs. The majority of its executive team are actually female. And even though it doesn't have a great racial diversity statistics. It is actually making it a goal to double the percentage of black and Hispanic employees by 2023. And given the recent George Floyd protests and Black Lives Matter situation, they're also donating a $1 million toward justice and reform and black-led institutions. So, they do a very good job.

And another area I'd like to, sort of, outline, another emerging area, would be the COVID-19 pandemic. I feel like that is an important part of the "S" equation that has emerged within, obviously, the last six months. And Etsy did a really good job of getting ahead of that by forming a task force early about what they were going to do to address the coronavirus. They moved very quickly to mobilize their sellers to make masks, for example, that helped a lot of people have masks when there really weren't any around. So, I felt like that was a very impressive and quick response to a pretty much unprecedented public health concern.

Southwick: All right. Let's move on to the third component, which is governance.

Lomax: Yes. Governance is actually, has to do with the systems and processes by which you run a company. Which, sort of, in layman's terms is basically, you know, you're looking at the board of directors, you're looking at management, how they're running things. You're looking at incentives, like CEO pay.

I think a good example of a company that does a good job on the corporate governance side of things is Accenture. It has things like majority voting, which means you need a majority of votes to elect boards of directors, members of the board. They have an unclassified board, which means actually, shareholders can vote out the entire board at one time. Some companies have classified boards where you can only vote out a few every couple of years. They also have proxy access, which means that shareholders can get a slate of their own director nominations on to the proxy statement. Another thing they have is, this is pretty unusual, that excepting the CEO and chairman, 100% of their directors are actually independent directors, usually there are -- many directors might be sort of related to the company. And so, it's pretty unusual to see 100% that are independent. Thirty-six percent of their board are women. And the ethnic diversity on their board of directors is 55%, which is actually a very strong showing.

Southwick: So, as an expert in ESG investing, can you tell us a little bit about your process for how you start to evaluate a company? Do you just start at the top and go, OK, "E," let's go? [laughs]

Lomax: Yeah, I actually do have a framework that I have developed over the years of studying this area. And it has a variety of different things I look for with each company. I do kind of usually do the "E" first and then move on through "S," "G." And what I'm looking for really does depend on very good disclosure from companies. So, you're going to look for a sustainability report that is very transparent and actually discloses this information.

And then there's also a framework that people can find on Fool.com, the ESG Compounders Checklist that my colleague John Rotonti and I put together, so they can go through the paces themselves.

Southwick: So, if there aren't any disclosures, that's just a non-starter for you. If you're like, well, this company doesn't have a sustainability report, I'm not even going to go any farther with them.

Lomax: Yeah, a lot of the time, if I'm not seeing good disclosure, I don't feel like I have enough to go on. And that is one of the difficulties with ESG analysis. A lot of the bigger companies are much better about disclosing these. So, with the medium and small companies, it makes it more difficult to tell. If there's just a very strong feeling that a company is doing a really good job, I think it's worth looking into, but really, the disclosure is very important. And that is how I hinge most of my investing, it is looking for a good disclosure.

Southwick: So, if you, as an ESG investor, does that mean that all of the companies you personally invest in, like, have a commitment to environmental, social and corporate governance or are there some companies where you're like, "Well, this part of my " -- right? Is it like an asset allocation question or is it, this is just how you invest, like, this is all of my stocks that I'm going to invest in care about ESG?

Lomax: Yes, all of my socks that I invest in, I truly do believe have strong characteristics in these areas. I would say that sometimes there's a trade-off where one piece of the ESG puzzle isn't as strong as the other pieces of the ESG puzzle. For example, corporate governance, I feel like there are some areas there where I might not feel like it's as strong, and I will view it as possibly a risk. But given the reality of the marketplace, there are certain things that are hard to avoid. For example, CEO pay is very often out of control in the U.S. So, I might have a company where I feel like, well, their "E" and "S" pieces are very strong, but the CEO is incentivized a little too highly. It's the kind of thing that you keep your eye on as a risk and, you know, as a shareholder, even when you're a small shareholder, you know, you can vote against pay. And their say on pay, votes every year.

So, I think one caution for people is that, being a purist is not going to work out. Most companies are going to have something where you're like, eh, that really needs to be addressed or be done better. So, to have a little bit of -- one of my favorite quotes is, "Don't let the perfect be the enemy of the good." So, just to say, you know, look for these areas, but sometimes you're going to have a few pieces of the puzzle that might not be as strong.

Southwick: Yeah. I know one of the big talking points around ESG investing is that millennials really want to invest alongside their principles in companies that support ESG. So, are companies authentically committed? Because you would think in the past when it wasn't so much, like, I don't want to say pandering, but are there companies who do that, where they're like, well, our consumers or our investors are holding our feet to the fire here. They want us to do it, so, OK, we'll put out a report. We'll say we're going to do this. How do you actually know when a company is authentically committed to this?

Lomax: I think that's something that everybody has to be very, very vigilant about keeping track of what the companies are saying and then whether they're actually making legitimate actions in those areas. That definitely requires, like, paying attention to the sustainability reports over time, are they making the goals, do they keep on moving the goalposts because they're not making them, are they saying, you know, a big game but not actually doing anything in that area? Like, you know, right now we do have a lot of companies that are putting out a lot of great statements about George Floyd and Black Lives Matter. We need to see them actually doing things to back up what they're saying. Are they, you know, donating money to organizations, are they disclosing their workforce and their executive team racial diversity stats, are they making real goals to improve those areas that they're lacking?

So, like I said, you know, you have to sort of temper it with, you know, everybody is trying to make progress, but then make sure that there is progress being made. I think, within the last six months, between COVID and the ideas of racial justice in this country, I think, we are going to see which companies really, really mean that they want to be good for stakeholders or not by their actions.

Southwick: So, this is an embarrassing thing to admit, but I had been an investor for way too long before I suddenly realized that investing my money in these companies doesn't actually mean that I'm supporting these companies. Like, if they were privately held companies and I invest in them, then yes, they would take that money, it would invest in their business, the business would grow, flourish, etc., but for companies that are publicly traded, I invest in them and actually my money is just going to Bro, who just sold me the shares.

And so, when we think about, how, when we're investing in these companies and we're supporting them and, you know, we're thereby proxy supporting their causes that they support. But you're not really making the world a better place [laughs] by investing in companies that are ESG-focused, are you? I mean, isn't it just more symbolic than actually making the world a better place through your investing?

Lomax: Right. There is a symbolic component with that. I think you're absolutely right about that. I do think that when we buy shares of a company and we're part-owner, I do believe that that comes into play. And if we're holding them for the long term, in that regard, we are supporting them in that way.

We also have our tiny voting rights, which I always like to talk about, like, of course, we're all small investors and, you know, we're not going to move the needle in voting in some of the ESG-related stockholder resolutions that show up in the proxy statement every year. But the truth is, the more people get together and vote on some of these issues, you know, together you are sort of a force. And I do kind of see it as like, you know, we direct our buying decisions often along these lines too where we're like, well, I don't want to support XYZ company with my spending money, which I think is similarly like, you're a small part of what can become, sort of, a bigger support or detractor.

If enough people are all like, such and such company is just doing a terrible job at, it's just terrible to its employees, if enough of us band together and refuse to frequent that company or buy its shares, I think that does, sort of, make a difference.

Southwick: Yeah. Well, the line is that ESG companies outperform over time. And so, one of the reasons why you invest in them is because they are going to do well for you as an investor. Does that actually bear out? Is it true that these companies do outperform over time?

Lomax: Yes, that is true. There is actually a lot of information out there that shows that kind of an outcome. Data from Arabesque found that S&P 500 companies that ranked in the top quantile for ESG factors outperformed those in the bottom quintile by more than 25 percentage points, assuming the beginning of 2014 and the end of 2018. And their stock prices were also less volatile. Again, over the last 10 or 15 years, the more and more practitioners there were, the more and more data we have been able to get over a long time. So, that still continues to bear out.

And I just ran into an article earlier today from JUST Capital that pointed out that companies that disclose their diversity statistics transparently tend to outperform. So, that's another, sort of, interesting related factor that goes on there. The idea that, you know, diverse companies actually do really well, because you have diversity of thought and you have different perspectives. Groups of people where everybody is the same, they just don't make as good decisions as more diverse groups, so that's just an interesting, sort of, subpoint right now.

Southwick: What do you think is a common misperception about ESG investing? Are there any out there?

Lomax: There are a lot out there about ESG and SRI [socially responsible investing] and all of the areas of stakeholder-centric investing, that you always have to give up returns and performance in order to invest this way. And I think that that is most definitely a myth that needs to just go by the wayside, because, like I said, there is a lot of research that shows that high-ESG companies do really well, that people who invest this way really aren't sacrificing returns. So, I think that's a huge misperception.

Brokamp: If you don't want to do all the digging yourself, are there other companies that will rate other companies in terms of these ESG factors? Like, I know Morningstar has some stewardship ratings and maybe some sustainability ratings. Are there other companies that you think people can go to, say, like, "I'm interested in this stock, I don't have the time to do all the ESG enquiries on my own, I'll see what this company thinks?

Lomax: Well, JUST Capital does some really, really amazing work in ranking companies according to these stakeholder areas. So, I highly recommend that people go check out their website and go see their rankings. There's just really great research there.

Another company that does this kind of work in Sustainalytics, they tend to look at ESG risk for companies. And while they are a service, so, you know, people pay a fee for that, Yahoo! Finance, on their stock pages, you can go, put in a ticker symbol and look up a company and you can actually see an ESG area where it shows whether Sustainalytics has marked it as high ESG risk or not.

And one thing I didn't really cover as we were discussing is, there is an argument that companies that are risky in ESG areas, you might want to avoid, you might want to be careful. I mean, there is a very real risk that, sooner or later, it can really hurt your returns.

Southwick: All right. Well, before we go, what's your recommendation for our audience that wants to learn more about ESG investing? I know you mentioned a framework that you and John posted to Fool.com, John Rotonti.

Lomax: I sure did. John Rotonti and I did produce a checklist on Fool.com. If you google "Fool.com and ESG factors" you'll find actually a variety of different articles, also a primer that is more in-depth than what I've been describing verbally. We have a long primer about the area, and like I said, the checklist and some companies that got run through the checklist. So, that could actually be a springboard for people who want to start doing this on their own.

Southwick: Great. Alyce, thank you so much for joining us.

Lomax: Thank you for having me.

Southwick: Well, that's the show. It's edited rationally by Rick Engdahl. Our email is [email protected]. For Robert Brokamp, I'm Alison Southwick. Stay Foolish, everybody!