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ESG Analysis Is Like Doing A Background Check On Your Portfolio

Most companies when hiring new employees will conduct a background check on all potential new hires. In addition to the standard reference check many companies will also conduct a criminal and credit check and depending on the position might talk to past colleagues and supervisors. Combining all these factors together gives them a score as to how trustworthy this person is, how reliable, and based on their criminal past - the likelihood of a violent outburst. By avoiding people with low background scores, companies hope to decrease the chances for serious situations which might bring liabilities and instability into the company.

Instability is known by another name when we are dealing with a securities portfolio: volatility. As investors we have two financial objectives, increase returns and decrease volatility. The standard tools for decreasing volatility have been diversification, investing into larger cap companies, and investing into companies that have predictable and stable profits, and now there is another tool: ESG analysis.

ESG analysis is the background check that rates the Environmental, Social, and Corporate Governance performance of a particular company. For example, just like a business might want to avoid an employee with a violent criminal record, an investor would hope to stay away from a company that has, for instance, a poor environmental record. Why? Because aside from polluting, such a company will be at a higher risk for an environmental disaster that could cost investors dearly. Likewise, a company with a low social score will be at a higher risk for litigation based on regulatory violations, which again creates volatility for the company and it's investors.*

On the other side are companies that are best in class and have high ESG scores. These companies not only behave in a socially responsible manner but also demonstrate the superior competence of their executive teams. Companies with high ESG scores will be more appealing to costumers, have an easier time with regulators, and in the end, decrease the chances of a negative company-specific event. As ESG information becomes more widely available we also believe that the company's ESG score will become more highly correlated with it's stock price.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.