Forget labelling, look at risks that could hurt a stock

Jul 18, 2023

Alan Kohler, journalist and anchor at the Australian Broadcasting Corporation, created a fair bit of a stir recently when he brought up the issue of the dramatic drop in the amount of sea ice in Antarctica.

Why does it matter? Shrinking of the reflective white surface that will result in less sunlight being sent back out of the atmosphere and more heat being absorbed by exposed dark ocean waters. Rising ocean temperatures. Melting glaciers. Rising sea levels. This impacts fishing and weather patterns globally.

The UN Environment Programme estimated in 2016 that the global cost of adapting to climate impacts is expected to grow to $140-300 billion per year by 2030 and $280-500 billion per year by 2050.

Last year, Deloitte released a report that estimated that unchecked climate change could cost the global economy $178 trillion over the next 50 years, or a 7.6% cut to global gross domestic product (GDP) in the year 2070 alone.

Kohler then ended with a warning: "That’s not finance yet, but it soon will be."

Morningstar’s Investment Specialist Shani Jayamanne counters that with “This is finance, and it always has been.

Shani Jayamanne explains.

ESG (Environmental, Social, Governance) risks are real and investing is about evaluating risk.

Investors increasingly view sustainability as a way to understand the vulnerability of their investment portfolios to ESG factors, instead of impact investing. This is an important distinction – because risk and return are intertwined. As an investor I want to be compensated for taking on risks. It is taking on risk that enables me to earn returns. However, in order to actually do this, I need to look at the full spectrum of risks and how they impact the long-term cash flows generated by a company.

Adam Fleck, Morningstar Director of Research, ESG and Ratings, previously covered Coca-Cola. He says ‘How can I evaluate if Coca-Cola is a good investment if I don’t look at increased levels of drought when water is one the key ingredients in most of their products?’.

Beyond drought conditions, it is thinking about obesity, sugary beverage taxes that may get proposed, container deposit schemes that are in place due to environmental concerns related to waste.

These are all issues that are correlated to impact investing but have real implications to the risk and future value the company can generate.

Risks are intrinsic to our company level valuations at Morningstar. Our analysts evaluate which environmental, social, and governance issues are financially material for each company or industry. How companies are tackling these material risks and how these risks affect companies’ long-term value.

ESG investing is less about trade-offs and more about not putting our heads in the sand as investors when we evaluate companies. Much like Kohler, it is understanding that these ESG issues are not for investors to sleep better at night, but for all investors to understand the prospects of the company they are invested in.

Fleck explains that ultimately, high ESG risk companies can be equally as attractive as low risk ESG companies. Investors have to think about the price that they are paying for the value they are receiving, and whether they are being compensated for the risk that they are taking on. Markets can and will be overly focused on near-term issues. If the share price moves due to an event and it is an overreaction, that may be an opportunity for investors.

Kristoffer Inton, equity strategist, ESG, for Morningstar, says that being conscious about ESG issues is not about feeling good. ESG should matter to investors because it identifies potential risks that could affect a stock price. Just like investors would want to know if a company could run into trouble from having too much debt, or selling products in a declining industry, it is important for investors to consider ESG risks that could hurt a stock.

For example, chemicals companies face risks from environmental damage that can ultimately cost billions of dollars to clean up, such as asbestos lawsuits that left many companies bankrupt. Similarly, beverage companies must continually monitor their water use as they may have to pay higher costs or even stop producing beverages if they use too much water. Any company whose employees are unionized is at risk that their employees will go on strike due to poor working conditions. All of these are ESG risks that could hurt investors.

Issues that are detrimental to the long-term value of the company should be important to you as an investor or shareholder, regardless of your stance on ESG.

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