Sustainability and the Stock Market
A game changer for company value?
By Jeff Zelkowitz
United States retirement plans have lost trillions of dollars since the subprime meltdown began. The ultimate flight to quality is under way as investors search for safety. The repercussions of this crisis are likely to be far-reaching in how shareowners assess future risks and how they view long-term corporate sustainability.
Taking sustainability beyond the universe of socially responsible investment (SRI) and into the institutional mainstream is a potential game changer. And it has major implications for corporate strategy, reporting systems and communication.
It’s been quite a decade for investors. Corporate scandals and greater recognition of environmental and energy impacts have already taught them to think differently about risk and opportunity. When former Vice President Al Gore teamed up with David Blood of Goldman Sachs to launch Generation Investment Management, their intention was to establish a model that recognizes the materiality of environmental, social and governance (ESG) factors as long-term value drivers. This not your father’s SRI, which relies mainly on social screening or advocacy at shareholder meetings. This firm (instantly nicknamed “Blood & Gore,” of course) is part of a growing trend of financial institutions seeking to incorporate sustainability into the traditional company valuation framework.
Leading corporations have generally been ahead of financial markets in their strategic understanding of and investments in sustainability. Markets generally do a good job of penalizing the stock prices of companies hit with financial disasters, major liabilities arising from pollution or health risks or those with governance problems. But so far, they have been slower to connect the dots on long-term ESG impacts that could put the value of a business at risk—or enhance its long-term value.
While studies have not shown a strong correlation between a company’s sustainability and its stock price, analysts have had some success in relating ESG performance to material risk factors, industry competitiveness and return on investment. Companies that manage risk effectively lower their liability exposures and their cost of capital. Companies that integrate sustainability into management processes can also strengthen resource efficiency, organizational performance and opportunities to increase revenues and cash flow.
As a result, corporate sustainability should mean everything for pension funds, insurance companies and investors who seek to cover their long-term liabilities. Billionaire investor Warren Buffett is recognized as successfully valuing sustainability of economic returns as the basis for long-term investing—and for going beyond what can be captured on income statement or balance sheet accounting for uncovering long-term value.
But there are structural and cultural challenges to overcome for most investors and analysts. One such challenge is the focus on short-term financial metrics at the expense of harder-to-measure sustainability issues that could have a material effect on business conditions and performance over a three-to-five year horizon or longer. Investors and analysts are trained to analyze financial data. They have trouble valuing ESG factors—also known as non-financial or extra-financial items—just as they do other intangibles such as brands and reputation. The level and quality of corporate reporting on sustainability issues is improving due to standards such as GRI. Yet we are still at an early stage of developing the systems and metrics for reporting non-financial factors, and the mainstream financial world has done relatively little to process what information is available into the investment equation.
That’s the opportunity that the new generation of investors is seeking to exploit. Given the vastly increasing role of sustainability in the development of corporate strategy, it is clearly in the interest of business leaders to educate the financial markets on how these factors are linked to company value. Chief financial officers and investor relations officers are rarely involved in these efforts and will need to develop approaches for tracking and communicating material information related to sustainability, so that it can be effectively digested by financial constituencies and reflected in the market’s opinion of the stock.
Likewise, CEOs can help by spending more time discussing long-term strategic issues and ESG value drivers with the financial markets. Specifically, they can set the tone by demonstrating how their sustainability commitments factor into value creation and protection of the firm’s long-term economic interests. Managements that figure out how to communicate successfully on these issues will be in the best position to secure buy-in from shareowners—and to achieve the maximum sustainable valuation for their businesses.
Jeff Zelkowitz is a senior vice president at APCO Worldwide and is based in New York.