Investments  

Focus on sustainability can improve long-term prospects

This article is part of
Ethical Investing - February 2014

The principal aim of actively managed, sustainable and responsible investments (SRI) is to outperform conventional benchmarks. The proviso is that they only invest in companies defined as more sustainable.

Some commentators deem this additional criterion a hindrance. However, it can give SRI funds a distinct advantage.

It is rare to find companies that can maintain strong growth in profitability across many years. The conventional way to identify these special cases is to assess them using the concept of Porter’s Five Forces. If these elements are satisfied, then the company is more likely to prevent margin erosion and loss of market share or decline in revenues.

Sixth force

However, there is an additional element – a sixth force if you like – that helps to identify businesses that can maintain growth. This factor is the sustainability of the company. Simply put, it is the belief that a company that is acting in the long-term interests of society is more likely to be supported by that society.

Michael Porter himself alluded to this (in the Harvard Business Review in 2011), when he states: “Not all profit is equal. Profits involving a social purpose represent a higher form of capitalism; one that creates a positive cycle of company and community prosperity.”

So, analysing a company’s sustainability helps to identify the potential for long-term, profitable growth. And conversely any company with poor sustainability characteristics will find growth more challenging. This was recognised in a recent Accenture survey of 1,000 CEOs, where 90 per cent agreed that sustainability is important to the future success of the company.

So much for the theory, how does it work in practice?

Any company should be strong on three counts: sustainability, business fundamentals, and valuation. If any of these are weak, they should not be considered.

Sustainability

What does the company produce and does this improve quality of life or reduce environmental impacts? Does it have high social utility? Furthermore, how is it managed? For instance, does the company have strong governance, a good record on environmental pollution, good employee relations, low absentee rates, and a clear long-term strategy?

Four major sustainable development, themes to consider are:

• Climate change. Every major economy has legislation in place to decarbonise and improve energy efficiency.

• Quality of life. Lifestyle diseases account for more premature death than infectious diseases globally. Education drives economic success.

• Sustainable consumption. Population and affluence are increasing. To keep resource consumption and pollution levels stable, efficiency needs to improve rapidly.

• Resilience. Successful economies need to be robust and secure. Companies involved in protection, security and stability will flourish.

Business fundamentals

Sustainability aside, is it a robust business – one that is able to maintain pricing, market share and margins? Can it reinvest cashflow for growth and maintain high returns on equity relative to its cost of capital? Does it have a strong balance sheet? Is it managed for the long-term interests of its shareholders? And is it possible to forecast future profitability?