Esg (Environmental, Social and Governance) strategies — all the rage with today’s investors — have received pushback from an unlikely quarter. At a June 23 webinar, Jay Clayton, Chairman of the U.S. Securities and Exchange Commission, argued that “E,” “S” and “G” cover different matters. Lumping them together into one, subjective score diminishes their usefulness, Clayton argued.
Chairman Clayton’s message is not what some of the biggest players in finance want to hear. “It is time for ESG investing to become mainstream,” declared Isabelle Mateos y Lago, BlackRock’s global macro investment strategist, three years ago. “In the research process of every team at BlackRock, we are increasingly ensuring that they take ESG into account.” When the world’s largest asset manager, with $7.4 trillion of assets under management, embraces ESG investing, its ultimate triumph appears pre-ordained.
Enter Alex Edmans, professor of finance at the London Business School, whose new book Grow the Pie challenges many of the assumptions underlying the case for ESG investing. Unlike those with an ideological axe to grind, Edmans comes to the debate bearing data, lots of it, skillfully distilling a wide array of academic research. While they may fail to impress those on either side of the debate who’ve already made up their minds, Edmans’s insights are fresh, often surprising, and always thoughtful and thought-provoking.
Research shows most Socially Responsible (SRI) funds don’t outperform the market, Edmans says. Worse still for the claim that ethical investing is rewarded by higher returns, a portfolio in the Triumvirate of Sin — tobacco, alcohol, and gaming — beats its closest non-sinful comparators.
Dig under the artificial and sometimes self-contradictory ESG labeling — the “G” is for enhanced shareholder control while the thrust of ESG is to dethrone shareholders in favor of stakeholders — and a more nuanced and interesting picture emerges. Aggregating performance for 2,396 enterprises across 51 stakeholder issues (pertaining to the “themes” including community, governance, diversity, employee relations, product, environment, and human rights) reveals that those with high scores only beat the market by a statistically insignificant 1.5 percent a year. But firms that score highly on issues material to their businesses and low on immaterial ones beat the market by a statistically significant 4.83 percent annually.
Edmans pioneered research into a highly material aspect of “S”: employee satisfaction. Examining the stock performance of the 100 Best Companies to Work for in America from 1984 to 2011, Edmans found they delivered returns that beat their peers by an average of 2.3 to 3.8 percent a year, or 89 to 184 percent cumulatively. The Parnassus Endeavor Fund, started in 2007 with the sole investment criterion of employee satisfaction, has delivered annual returns of 12.2 percent a year, beating the S&P 500 Index’s 8.5 percent return. “Treating colleagues a partners in the enterprise, rather than as a resource to be exploited or a cost to be minimized, benefits both workers and Wall Street,” Edmans concludes.
While Edmans advocates businesses’ investing in their stakeholders, growing the pie is no pie in the sky. “It takes no skill to simply spend money,” he notes. Profits are valuable signals for what society wants. “Investing beyond the point where the social benefit justifies its cost will shrink rather than grow the pie,” an example being the Japanese practice of not laying off employees but sending them to molder away in “banishment rooms.” Edmans offers three principles to guide pie-growing spending and reduce the risk that it is socially wasteful: multiplication (so that the value to stakeholders exceeds private costs), comparative advantage (utilizing the firm’s core competencies), and materiality to the business and its activities (so there’s a good chance of benefit flow-back to the enterprise). “Investing in immaterial stakeholder issues doesn’t improve returns,” researchers at Harvard Business School found.
Edmans is a strong believer in the social good: “To reach the land of profit, follow the road of purpose,” he says. That might make Edmans sound as if he has signed up for the fashionable pieties of woke capitalism, but Edmans has too much integrity as a scholar for that: He plows his own furrow. CEO pay too high? The increase in U.S. CEO pay between 1980 and 2003 can be fully explained by the rise in firm size. The problem is not the level of CEO pay, but its structure, complexity, and time horizon. Pay ratios? They’re lower at Goldman Sachs than JP Morgan because the latter employs bank tellers. In any case, leaders’ pay should be tied to their performance in growing the pie, not paying workers. Stock buybacks — the bêtes noire of senators Elizabeth Warren and Marco Rubio? One dollar of cash left on balance sheets in poorly governed companies is valued by the market at only $0.42 to $0.88. That is why S&P 500 firms buy back more stock than they issue, while non-S&P 500 firms do the opposite. “The stock market’s role is to allocate scarce funds to companies where they’ll benefit society the most,” Edmans argues.
Unlike critics of capitalism, Edmans accepts its basic premise. “Without profits, shareholders wouldn’t finance companies, companies couldn’t finance investments and investments couldn’t finance shareholders’ needs (citizens’ retirements, insurance companies’ claims or pension funds’ liabilities),” he argues. “Thus, ideas to reform business that ignores profits’ crucial role in society are unlikely to be implemented — enterprises aren’t charities.” Rather, Edmans urges companies and investors to seek profits by creating value for society, thereby expanding the total value available to shareholders and stakeholders. “Creating social value is neither defensive nor simply ‘worthy’ — it’s good business.” One doesn’t have to agree with every one of Edmans’s recommendations to respond positively to the spirit that infuses his writing: Optimism, supported by copious evidence, about the potential for positive-sum outcomes to transform business performance and its contribution to society. It is a tonic for our times.