The surging popularity of environmental, social, and governance (ESG) issues in recent years rests in part on the growing recognition that ESG issues can be material. Nasdaq.com defines materiality as “The importance of an event or information in influencing a company’s stock price.” While the concept may be more familiar to auditors and analysts, average investors can understand that materiality means money is at stake.
Material issues can include a wide variety of things:
Material issues can include a wide variety of things: a change in a company’s leadership, a natural disaster that damages a company’s facilities or transportation infrastructure, a merger or an acquisition, a clinical trial or patent. When news or events occur, analysts must make a judgment about whether it is material by estimating its impact on value and whether it is likely to affect the stock price.
The link to ESG issues
As ESG issues became more prominent in recent decades, investment and accounting professionals were generally slow to recognize that they could be material, in part because they emerged outside of traditional financial statement analysis. But the recognition grew. Companies that polluted could face greater cleanup costs or legal liabilities. Businesses that treated employees poorly had reputational risk and higher operating costs. Poor governance could lead to lax financial controls. The question for fundamental investors was just how material were these issues? Researchers found that the materiality of issues often varied by sector. This might seem like common sense, but establishing the relevance of materiality was a breakthrough in understanding how ESG issues had an impact on stock performance over time.
Putnam’s equity materiality map
At Putnam Investments, Katherine Collins, CFA, MTS, Head of Sustainable Investing, leads a research team that has developed an equity materiality map that tracks ESG issues across each sector of the market. Collins notes that it is a streamlined version of the Materiality Map pioneered by the Sustainable Accounting Standards Board (SASB), which worked over many years with companies, investors, and other constituents to create a thoughtful and thorough guide. This business-specific approach suits Putnam’s fundamental process. “When our analysts meet with the CEO of a beverage company,” Collins says, “they naturally ask different questions than they ask the CEO of a software company. And both of those sets of questions are different from the questions they ask the CEO of a mining company, and so on.”
The map guides the work of Putnam’s Equity Research team on sustainability issues. The team utilizes data from several third-party resources, including MSCI and Sustainalytics, but believes in the power of context-specific analysis. “We believe that this kind of integrated, long-term research has the potential to mitigate risk and to generate above-market returns,” Collins says.
To give an example of how the system works, Collins describes how the map helps the team analyze consumer product-packaging technologies, such as aluminum and plastic beverage containers. In its sustainability analysis, the team considered several layers of the map — materials sourcing and intensity, recycling and reuse potential, and energy use — for starters. These layers of analysis shed light on key advantages of aluminum. It has a higher recycling rate than plastic, and when it is recycled, the output is high quality. The research team combined this understanding of sustainability with traditional fundamental analysis to find a maker of aluminum containers that had made strategic investments to benefit from the advantages of this material. The company was beginning to reap the rewards of these investments.
Unlocking intangibles
Collins sees power in the map. One of the major tasks for fundamental analysts today is estimating the value of corporate intangible assets. Factors such as brand value, customer loyalty, employee motivation, patents, and intellectual property, among others, now represent about 85% of the value of S&P 500 companies, but traditional analytical tools are not designed to measure them. “I would argue that understanding the relevant environmental, social, and governance issues for any given company is essential to solving the puzzle of how to estimate the value of intangibles,” Collins says.
For the future, Collins believes that it’s a key due diligence question to ask an ESG manager how they think about materiality. For some, ESG analysis remains separate from investment analysis. But Putnam’s approach is integrated and additive. It requires extra work, Collins admits, but a “true fundamentally integrated ESG approach means that you look company by company, industry by industry, sector by sector, to figure out the most important environmental, social, and governance factors that are going to influence this company’s success in the long term. That’s where we see the intersection of sustainability benefits and financial benefits.”
Consider these risks before investing: Growth stocks may be more susceptible to earnings disappointments, and the market may not favor growth-style investing. The value of investments in the fund’s portfolio may fall or fail to rise over extended periods of time for a variety of reasons, including general economic, political, or financial market conditions; investor sentiment and market perceptions; government actions; geopolitical events or changes; and factors related to a specific issuer, geography, industry, or sector. These and other factors may lead to increased volatility and reduced liquidity in the fund’s portfolio holdings. From time to time, the fund may invest a significant portion of its assets in companies in one or more related industries or sectors, which would make the fund more vulnerable to adverse developments affecting those industries or sectors. You can lose money by investing in the fund.
More in: Sustainable investing