ESG investing is a form of investing considered to be socially responsible. This form of investment prioritises financial returns alongside a firm’s impact on the environment, its stakeholders, and the planet.
When the market crashed, many investors turned to ESG stocks. Their recent rise in popularity has been intriguing. With that in mind, I explain what ESG investing actually means and where it comes from. I also identify one ESG pick I like for my portfolio.
What does ESG investing actually mean?
‘E’ stands for environmental. This aspect of ESG investing refers to a firm’s effect on the planet. This can be via a multitude of channels such as carbon footprint, renewable energy usage, recycling, and climate change policies. In addition, the firm’s relationships and commitments towards environmental agencies and bodies are also considered.
‘S’ stands for social. This aspect refers to issues affecting a firm’s own workforce, its customers and suppliers, as well as the local community. Some of the social aspects this covers include how a firm compensates and treats its workers, as well employee engagement and staff turnover rates. More pressing issues include safety policies and practises related to sexual harassment prevention as well as diversity and inclusion. Furthermore, ethical supply chain sourcing has been a big focus in recent times.
‘G’ stands for governance. The governance aspect of ESG investing relates to a firm’s leadership and how well it governs itself as an organisation and if it operates ethically. More specifically, this can cover things like executive compensation packages and the makeup of a board in terms of diversity and inclusion. In addition, this includes a focus on business policies to ensure they are in line with ethical practises as well as shareholder management.
History of ESG investing
The topics noted above for each aspect are just a snapshot. The overall list can be much longer depending on a firm’s ESG commitment. I must note that this type of investing is not a new model of investing.
An example of a form of ESG investing can be traced back hundreds of years ago, linked to the Islamic faith. Muslims established investments that complied with Sharia law, which included prohibitions on weapons. The very first ethical unit trusts in the US and UK were developed by Quakers and Methodists.
I believe that ESG investing officially entered the mainstream following the release of the Principles for Responsible Investments (PRI) in 2006. This is a set of United Nations guidelines for the incorporation of ESG factors into business strategy and its policies. The PRI has over 2,000 signatories. It is widely considered an official point of reference for all things related to ESG investing.
Recent investor attention
Why has ESG investing seen such a rise in popularity recently? The financial performance of some ESG stocks has seen more and more savvy investors drawn to this strategy in the past two years. When the market crashed due to the Covid-19 pandemic, many firms with solid ESG credentials actually showed lower volatility than non-ESG stocks.
Looking at the 2020 pandemic market crash more detail, many investors turning towards ESG funds. In the first three months of 2020, $45.6bn flowed into these funds globally. In the next two decades alone, there could be approximately $50trn sitting in sustainable investment trusts.
Better risk management and decision-making
I believe there is a pattern of investors looking to fund organisations that support sustainability and complying with emerging regulations such as reducing carbon footprints and climate change. I believe investors are also looking for more transparency in what they are investing in.
The favourable performance of ESG stocks is validating this method of investing and its principles. In simple terms, good corporate behaviour could mean better business results. I must note there is no widely accepted criteria as to why ESG stocks do perform better in a time of market volatility. Some point towards better leadership and long-term decision-making. A case can also be made for better risk management linked to ESG principles that has benefited ESG stocks.
I like to learn about any investing methodology or practise before I invest my money. I found there is a UK ESG Select Index. It is designed to measure the performance of the top FTSE 100 firms as demonstrated by their ESG practises. I plan to keep a keen eye on this index.
1 ESG stock I like
One pick I like for my portfolio when considering ESG investing is packaging firm DS Smith (LSE:SMDS). It is a major player in its respective market and produces packaging for retailers and industrial customers too. With the rise of online shopping, there is a high demand for packaging.
DS Smith only produces cardboard packaging and promises to use recycled materials where possible. In addition, it is attempting to ensure its packaging is recycled again after use. From an ESG investing perspective, it ticks a lot of boxes.
The DS Smith share price has surpassed pre-crash levels which is encouraging. As I write, shares are trading for 404p per share. In the past 12 months, the share price has increased from 310p per share to current levels which is a 30% return.
DS also has a good record of performance. However, I understand that past performance is not a guarantee of the future. Revenue has been above £5.5bn consistently for the past four years. Gross profit increased year on year for three years prior to the pandemic period. This was to be expected as consumer spending habits changed due to economic uncertainty when the pandemic struck.
DS Smith does have real risks too. Firstly, a lot of change for the packaging producer has seen its debt levels rise. They are probably a bit higher than I would like as a potential investor. If there were any issues with this, the share price could fall. Finally, the potential increase in labour and transportation costs could impact the financials and therefore investor return which is something I must be wary of.
Overall, I do like DS Smith as a good ESG investing option for my portfolio. With reopening in full swing and ESG investing on the rise, DS Smith could benefit and be a good addition to my portfolio. At current levels I would buy shares.
