Why ESG Makes Us Better Value Investors

March 17, 2021

What exactly is ESG investing? If it’s defined as any approach used by signatory firms to the UN-backed Principles for Responsible Investment (PRI), then the vast majority of professionally managed financial assets are invested in this way—recent figures show that more than $100 trillion is now managed by PRI signatories, up from around $20 trillion in 2010.1 By comparison, the sum of professionally invested capital in 2020 was approximately $112 trillion.2 Does this mean that over the last decade, investment managers have fundamentally changed the way they do business?

ESG stands for environmental, social and governance. At Harris Associates, we don’t consider ESG factors in isolation, but recognize that issues falling into these categories can be material to the companies we invest in. To us, this is not a separate strategy or an add-on to our existing process, but part of the overall set of issues we consider when making investment decisions. As research-driven, active investors, we have taken account of ESG factors since our firm was founded in 1976 – it’s just that back then, we didn’t use the term “ESG.”

The core of our approach can be summed up in one phrase: ESG integration is good investing. ESG integration is defined by the PRI as “the analysis of all material factors in investment analysis and investment decisions, including environmental, social, and governance factors.3” This definition has two important implications. Firstly, that taking account of E, S and G issues in this way is firmly in line with traditionally accepted and legally mandated concepts of fiduciary duty. If an issue is material, it should be considered by a prudent investor, regardless of its categorization. And secondly, that not all ESG issues are material for any given investment. This is intuitively apparent: for example, data on sulfur dioxide emissions can help investors estimate the compliance costs for an electric utility, but are meaningless when applied to an investment bank.

This concept of “materiality,” or how economically important an ESG factor is for any specific investment, is important because it points to a key risk of ESG data, namely that it can be used in inappropriate or misleading ways. If investors rely on an ESG score that does not focus on economically material issues, they risk making bad investment decisions as a result. Indeed, in a landmark paper on this topic, academics from Harvard Business School and Northwestern University demonstrated that investment-useful signals can be derived from ESG data, but only if the non-material ESG data points are excluded.4 This implies that smart data usage can help investors seeking to generate better financial returns for their clients, provided they can correctly identify which factors are meaningful.

At Harris Associates, we recognize the materiality of ESG data as part of a prudent investment process that seeks to maximize long-term shareholder value while accounting for risk. This way of thinking is a natural fit for our value-oriented approach to investment. The three components of this approach, and the way ESG considerations apply to each, can be summarized as follows:

We invest in companies we expect to grow per share value over time. Business quality, competitiveness and growth potential are often influenced by ESG factors. For example, Roche, one of our pharmaceutical holdings, aims to grow by doubling the number of medical advances it makes that will benefit society over the next decade, while reducing the overall cost to society. The company strives to achieve this via more targeted medications and curative therapies that reduce cost elsewhere in the system, hence making societal impact an important part of its growth strategy.

We invest with management teams that think and act as owners. We assess the quality of a company’s management when choosing stocks to invest in, and carry out extensive dialogues with executives to address corporate governance issues and to ensure their objectives are aligned with shareholders’ interests. One example of this is our multi-year engagement with the management team of Toyota Motor Corporation, during which we’ve encouraged them to create a more efficient balance sheet and allocate capital in ways that benefit all shareholders. The company’s management also recognizes the benefits of a diverse workforce. In 2020, Toyota Motor North America was ranked 10th on DiversityInc’s Top 50 Companies for Diversity list.5

We choose stocks that trade at a significant discount to our estimate of intrinsic value. Relevant ESG data represents an additional source of information to help us accurately estimate this intrinsic value, even if it has not been factored in by the market. For instance, in estimating the intrinsic value of Glencore plc, we take account of the regulatory and market risk associated with the company’s fossil fuel assets.

Our approach uses ESG data to help grow shareholder value, in contrast to impact investing strategies, where social and environmental objectives are targeted alongside economic benefit. However, it’s important to recognize that the idea of a trade-off between good financial returns and good societal outcomes is a false dichotomy. Good corporate citizens are good value creators, and there are many factors where ethical and financial performance are in step: diversity within a business brings in different perspectives and reduces groupthink; companies that treat their employees well are more likely to have a loyal and motivated workforce; those that manage their environmental impact may expect less legal and reputational risk; and so on.

Harris Associates is a proud signatory of the PRI. This commitment made sense for us, since we agree with the view stated in the preamble to the Principles that “environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time).6” There are many examples of companies whose performance has been affected by ESG issues, and as the PRI recognizes, the issues that matter can vary greatly between businesses. This application of relevant issues to an investment process, evaluating individual companies one by one, is key to an active, value-based approach to investing, such as ours. The PRI goes on to state that “[w]e also recognize that applying these Principles may better align investors with broader objectives of society.” We believe that this alignment with societal goals is also likely to be a byproduct of an approach that is focused on shareholder value.

1PRI Update, Q1 2021

2Asset and Wealth Management Revolution: The Power to Shape the Future. PwC, 2020

3ESG in Equity Analysis and Credit Analysis: An Overview. PRI, 2018

4Khan, M., Serafeim, G., and Yoon, A., Corporate Sustainability: First Evidence on Materiality. The Accounting Review, Vol. 91, No. 6, pp. 1697-1724. Nov 2016

52020 Top 50 Companies for Diversity. DiversityInc website, accessed March 2021

6What are the Principles for Responsible Investment? PRI website, accessed March 2021

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the author and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.

The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable.

Investing involves risk, including the risk of loss. Sustainable investing focuses on investments in companies that relate to certain sustainable development themes and demonstrate adherence to environmental, social and governance (ESG) practices; therefore the universe of investments may be limited and investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. This could have a negative impact on an investor’s overall performance depending on whether such investments are in or out of favor.

Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.

Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.